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Chapter 8 Principles PrinciplesofCorporateFinance Ninth Edition Introduction to Risk, Return, and The Opportunity Cost of Capital Slides by Matthew Will.

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Presentation on theme: "Chapter 8 Principles PrinciplesofCorporateFinance Ninth Edition Introduction to Risk, Return, and The Opportunity Cost of Capital Slides by Matthew Will."— Presentation transcript:

1 Chapter 8 Principles PrinciplesofCorporateFinance Ninth Edition Introduction to Risk, Return, and The Opportunity Cost of Capital Slides by Matthew Will Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin

2 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 8- 2 McGraw Hill/Irwin Topics Covered  Over a Century of Capital Market History  Measuring Portfolio Risk  Calculating Portfolio Risk  How Individual Securities Affect Portfolio Risk  Diversification & Value Additivity

3 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 8- 3 McGraw Hill/Irwin The Value of an Investment of $1 in 1900

4 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 8- 4 McGraw Hill/Irwin The Value of an Investment of $1 in 1900 Real Returns

5 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 8- 5 McGraw Hill/Irwin Average Market Risk Premia (by country) Risk premium, % Country

6 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 8- 6 McGraw Hill/Irwin Dividend Yield (1900-2006)

7 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 8- 7 McGraw Hill/Irwin Rates of Return 1900-2006 Source: Ibbotson Associates Year Percentage Return Stock Market Index Returns

8 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 8- 8 McGraw Hill/Irwin Measuring Risk Return % # of Years Histogram of Annual Stock Market Returns (1900-2006)

9 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 8- 9 McGraw Hill/Irwin Equity Market Risk (by country) Standard Deviation of Annual Returns, % Average Risk (1900-2006)

10 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 8- 10 McGraw Hill/Irwin Dow Jones Risk Annualized Standard Deviation of the DJIA over the preceding 52 weeks (1900 – 2006)

11 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 8- 11 McGraw Hill/Irwin 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.

12 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 8- 12 McGraw Hill/Irwin Measuring Risk Coin Toss Game-calculating variance and standard deviation

13 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 8- 13 McGraw Hill/Irwin Measuring Risk 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.”

14 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 8- 14 McGraw Hill/Irwin Measuring Risk

15 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 8- 15 McGraw Hill/Irwin Measuring Risk

16 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 8- 16 McGraw Hill/Irwin Measuring Risk

17 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 8- 17 McGraw Hill/Irwin Portfolio Risk The variance of a two stock portfolio is the sum of these four boxes

18 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 8- 18 McGraw Hill/Irwin Portfolio Risk Example Suppose you invest 60% of your portfolio in Wal- Mart and 40% in IBM. The expected dollar return on your Wal-Mart stock is 10% and on IBM is 15%. The expected return on your portfolio is:

19 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 8- 19 McGraw Hill/Irwin Portfolio Risk Example Suppose you invest 60% of your portfolio in Wal-Mart and 40% in IBM. The expected dollar return on your Wal-Mart stock is 10% and on IBM is 15%. The standard deviation of their annualized daily returns are 19.8% and 29.7%, respectively. Assume a correlation coefficient of 1.0 and calculate the portfolio variance.

20 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 8- 20 McGraw Hill/Irwin Portfolio Risk Example Suppose you invest 60% of your portfolio in Wal-Mart and 40% in IBM. The expected dollar return on your Wal-Mart stock is 10% and on IBM is 15%. The standard deviation of their annualized daily returns are 19.8% and 29.7%, respectively. Assume a correlation coefficient of 1.0 and calculate the portfolio variance.

21 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 8- 21 McGraw Hill/Irwin Portfolio Risk Example Suppose you invest 60% of your portfolio in Exxon Mobil and 40% in Coca Cola. The expected dollar return on your Exxon Mobil stock is 10% and on Coca Cola is 15%. The expected return on your portfolio is:

22 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 8- 22 McGraw Hill/Irwin Portfolio Risk Example Suppose you invest 60% of your portfolio in Exxon Mobil and 40% in Coca Cola. The expected dollar return on your Exxon Mobil stock is 10% and on Coca Cola is 15%. The standard deviation of their annualized daily returns are 18.2% and 27.3%, respectively. Assume a correlation coefficient of 1.0 and calculate the portfolio variance.

23 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 8- 23 McGraw Hill/Irwin Portfolio Risk Example Suppose you invest 60% of your portfolio in Exxon Mobil and 40% in Coca Cola. The expected dollar return on your Exxon Mobil stock is 10% and on Coca Cola is 15%. The standard deviation of their annualized daily returns are 18.2% and 27.3%, respectively. Assume a correlation coefficient of 1.0 and calculate the portfolio variance.

24 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 8- 24 McGraw Hill/Irwin Portfolio Risk

25 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 8- 25 McGraw Hill/Irwin Portfolio Risk Example Correlation Coefficient =.4 Stocks  % of PortfolioAvg Return ABC Corp2860% 15% Big Corp42 40% 21% Standard Deviation = weighted avg = 33.6 Standard Deviation = Portfolio = 28.1 Real Standard Deviation: = (28 2) (.6 2 ) + (42 2 )(.4 2 ) + 2(.4)(.6)(28)(42)(.4) = 28.1 CORRECT Return : r = (15%)(.60) + (21%)(.4) = 17.4%

26 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 8- 26 McGraw Hill/Irwin Portfolio Risk Example Correlation Coefficient =.4 Stocks  % of PortfolioAvg Return ABC Corp2860% 15% Big Corp42 40% 21% Standard Deviation = weighted avg = 33.6 Standard Deviation = Portfolio = 28.1 Return = weighted avg = Portfolio = 17.4% Let’s Add stock New Corp to the portfolio

27 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 8- 27 McGraw Hill/Irwin Portfolio Risk Example Correlation Coefficient =.3 Stocks  % of PortfolioAvg Return Portfolio28.150% 17.4% New Corp30 50% 19% NEW Standard Deviation = weighted avg = 31.80 NEW Standard Deviation = Portfolio = 23.43 NEW Return = weighted avg = Portfolio = 18.20% NOTE: Higher return & Lower risk How did we do that? DIVERSIFICATION

28 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 8- 28 McGraw Hill/Irwin Portfolio Risk The shaded boxes contain variance terms; the remainder contain covariance terms. 1 2 3 4 5 6 N 123456N STOCK To calculate portfolio variance add up the boxes

29 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 8- 29 McGraw Hill/Irwin Beta and Unique Risk beta Expected return Expected market return 10% -+ - 10%+10% stock Copyright 1996 by The McGraw-Hill Companies, Inc -10% 1. Total risk = diversifiable risk + market risk 2. Market risk is measured by beta, the sensitivity to market changes

30 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 8- 30 McGraw Hill/Irwin Beta and Unique Risk Market Portfolio - Portfolio of all assets in the economy. In practice a broad stock market index, such as the S&P Composite, is used to represent the market. Beta - Sensitivity of a stock’s return to the return on the market portfolio.

31 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 8- 31 McGraw Hill/Irwin Beta and Unique Risk

32 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 8- 32 McGraw Hill/Irwin Beta and Unique Risk Covariance with the market Variance of the market

33 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 8- 33 McGraw Hill/Irwin Beta

34 Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 8- 34 McGraw Hill/Irwin Web Resources www.globalfindata.com www.econ.yale.edu/~shiller Click to access web sites Internet connection required

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