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Fundamentals of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Alan J. Marcus Slides by Matthew Will Chapter 10 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Introduction to Risk, Return, and the Opportunity Cost of Capital

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Page 1: 11- 1 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Fundamentals of Corporate Finance Sixth Edition Richard

11- 1

McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved

Fundamentals of Corporate

Finance

Sixth Edition

Richard A. Brealey

Stewart C. Myers

Alan J. Marcus

Slides by

Matthew Will

Chapter 10

McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved

Introduction to Risk, Return, and the Opportunity Cost of

Capital

Page 2: 11- 1 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Fundamentals of Corporate Finance Sixth Edition Richard

11- 2

Topics Covered

Rates of Return: A Review A Century of Capital Market History Measuring Risk Risk & Diversification Thinking About Risk

Page 3: 11- 1 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Fundamentals of Corporate Finance Sixth Edition Richard

11- 3

Rates of Return

26.1%or .261=

75.06

37.123.18 =Return Percentage

P e rc e n ta g e R e tu rn = C a p i ta l G a in + D iv id e n d In i t ia l S h a re P r ic e

Page 4: 11- 1 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Fundamentals of Corporate Finance Sixth Edition Richard

11- 4

Rates of Return

D iv id e n d Y ie ld = D iv id e n d In i t ia l S h a re P r ic e

C a p i t a l G a in Y ie ld = C a p i t a l G a inIn i t i a l S h a r e P r i c e

Page 5: 11- 1 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Fundamentals of Corporate Finance Sixth Edition Richard

11- 5

Rates of Return

%1.8or 018.75.06

1.37= Yield Dividend

%24.3or 243.75.06

18.23= YieldGain Capital

Page 6: 11- 1 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Fundamentals of Corporate Finance Sixth Edition Richard

11- 6

Rates of Return

Nominal vs. Real

1+ real ror = 1 + nominal ror1 + inflation rate

%1.21ror real

211.1=ror real+1 .041 + 1.261 + 1

Page 7: 11- 1 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Fundamentals of Corporate Finance Sixth Edition Richard

11- 7

Market Indexes

Dow Jones Industrial Average (The Dow)

Value of a portfolio holding one share in each of 30 large industrial firms.

Standard & Poor’s Composite Index (The S&P 500)

Value of a portfolio holding shares in 500 firms. Holdings are proportional to the number of shares in the issues.

Page 8: 11- 1 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Fundamentals of Corporate Finance Sixth Edition Richard

11- 8

The Value of an Investment of $1 in 1900

Source: Ibbotson Associates

1

10

100

1000

10000

10000019

00

1910

1920

1930

1940

1950

1960

1970

1980

1990

2000

Common StocksLong T-BondsT-Bills

Inde

x

Year Start

$22,745

$192

$69

2008

Page 9: 11- 1 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Fundamentals of Corporate Finance Sixth Edition Richard

11- 9

Rates of Return

-60.00%

-40.00%

-20.00%

0.00%

20.00%

40.00%

60.00%

Ret

urn

(%

)

1900

1910

1920

1930

1940

1950

1960

1970

1980

1990

2000

Year

Common Stocks (1900-2007)

2007

Page 10: 11- 1 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Fundamentals of Corporate Finance Sixth Edition Richard

11- 10

Expected Return

7.6+2.2=9.8% (2008)

7.6+14=21.6% (1981)

premium

risk normal+

billsTreasury

on rateinterest =

return

market Expected

Page 11: 11- 1 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Fundamentals of Corporate Finance Sixth Edition Richard

11- 11

Country Risk Premia (%)

0

2

4

6

8

10

12Italy

Japan

France

Germany

Australia

S Africa

Sweden

USA

Average

Netherlands

UK

Norway

Canada

Ireland

Spain

Switzerland

Belgium

Denmark

Page 12: 11- 1 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Fundamentals of Corporate Finance Sixth Edition Richard

11- 12

Measuring Risk

Variance - Average value of squared deviations from mean. A measure of volatility.

Standard Deviation - Average value of squared deviations from mean. A measure of volatility.

Page 13: 11- 1 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Fundamentals of Corporate Finance Sixth Edition Richard

11- 13

Measuring Risk

Coin Toss Game-calculating variance and standard deviation

(1) (2) (3)

Percent Rate of Return Deviation from Mean Squared Deviation

+ 40 + 30 900

+ 10 0 0

+ 10 0 0

- 20 - 30 900

Variance = average of squared deviations = 1800 / 4 = 450

Standard deviation = square of root variance = 450 = 21.2%

Page 14: 11- 1 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Fundamentals of Corporate Finance Sixth Edition Richard

11- 14

Histogram of Returns

Return, percent

Num

ber

of Y

ears

Page 15: 11- 1 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Fundamentals of Corporate Finance Sixth Edition Richard

11- 15

Risk and Diversification

Diversification - Strategy designed to reduce risk by spreading the portfolio across many investments.

Unique Risk - Risk factors affecting only that firm. Also called “diversifiable risk.”

Market Risk - Economy-wide sources of risk that affect the overall stock market. Also called “systematic risk.”

Page 16: 11- 1 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Fundamentals of Corporate Finance Sixth Edition Richard

11- 16

Risk and Diversification

Deviations from SquaredYear Rate of Return, % Average Return, % Deviations

2002 -20.9 -29.4 864.362003 31.6 23.1 533.612004 12.5 4.0 16.002005 6.4 -2.1 4.412006 15.8 7.3 53.292007 5.6 -2.9 8.41

Total 51.0 1,480.08

Average return = 51.0/6 = 8.50%246.6815.71%

Variance = average of squared deviations = 1,480.08/6 = Standard deviation = square root of variance =

Page 17: 11- 1 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Fundamentals of Corporate Finance Sixth Edition Richard

11- 17

Risk and Diversification

Portfolio rate

of return=

fraction of portfolio

in first assetx

rate of return

on first asset

+fraction of portfolio

in second assetx

rate of return

on second asset

((

((

))

))

Page 18: 11- 1 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Fundamentals of Corporate Finance Sixth Edition Richard

11- 18

Stock Market Volatility 1900-2007

0

10

20

30

40

50

60

1900

1905

1910

1915

1920

1925

1930

1935

1940

1945

1950

1955

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

Std

Dev

2007

Page 19: 11- 1 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Fundamentals of Corporate Finance Sixth Edition Richard

11- 19

The Value of InvestmentsV

alue

(A

ugus

t 200

4 =

100

)

Page 20: 11- 1 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Fundamentals of Corporate Finance Sixth Edition Richard

11- 20

Risk and Diversification

05 10 15

Number of Securities

Po

rtfo

lio

sta

nd

ard

dev

iati

on

Page 21: 11- 1 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Fundamentals of Corporate Finance Sixth Edition Richard

11- 21

05 10 15

Number of Securities

Po

rtfo

lio

sta

nd

ard

dev

iati

on

Market risk

Uniquerisk

Risk and Diversification

Page 22: 11- 1 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Fundamentals of Corporate Finance Sixth Edition Richard

11- 22

Thinking About Risk

Message 1 Some Risks Look Big and Dangerous but Really Are

Diversifiable

Message 2 Market Risks Are Macro Risks

Message 3 Risk Can Be Measured

Page 23: 11- 1 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Fundamentals of Corporate Finance Sixth Edition Richard

11- 23

Web Resources


McGraw-Hill/Irwin Copyright © 2008, The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies, Inc

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1 McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter Seven McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc.,

McGraw-Hill/Irwin ©2005 The McGraw-Hill Companies, All rights reserved ©2005 The McGraw-Hill Companies, All rights reserved McGraw-Hill/Irwin

Chapter 11 · Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001 Chapter 11 Reporting and Interpreting Owners’ Equity. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc.,

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© McGraw-Hill Companies, Inc., McGraw-Hill/Irwin McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved

McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

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McGraw-Hill/Irwin ©2005 The McGraw-Hill Companies, All rights reserved McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

Relevant Costs for Decision Making - NELY BACHSIN BLOG · PDF fileChapter Thirteen . McGraw-Hill/Irwin ... McGraw-Hill/Irwin Copyright © 2008, ... McGraw-Hill/Irwin Copyright © 2008,

Irwin / McGraw-Hill

Irwin/McGraw Hill The McGraw-Hill Companies, Inc., 2000 · Slides by Matthew Will Chapter 2 Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 2000. Irwin/McGraw Hill ... " Tools

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Local Marketing in Mature Markets Chapter Eight. Irwin/McGraw-Hill ©The McGraw-Hill Companies,, Inc., 2000 Irwin/McGraw-Hill ©The McGraw-Hill Companies,,

Chapter 10 · Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2001 $ Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc.,

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