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**Principles of Corporate Finance**

Seventh Edition Richard A. Brealey Stewart C. Myers Chapter 7 Introduction to Risk, Return, and the Opportunity Cost of Capital Slides by Matthew Will McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved

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**Topics Covered 75 Years of Capital Market History Measuring Risk**

Portfolio Risk Beta and Unique Risk Diversification

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**The Value of an Investment of $1 in 1926**

6402 2587 64.1 48.9 16.6 Index 1 Year End Source: Ibbotson Associates 13

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**The Value of an Investment of $1 in 1926**

Real returns 660 267 6.6 5.0 1.7 Index 1 Year End Source: Ibbotson Associates 13

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**Rates of Return 1926-2000 Percentage Return Year**

Source: Ibbotson Associates 14

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**Average Market Risk Premia (1999-2000)**

Risk premium, % Country

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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.

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Measuring Risk Coin Toss Game-calculating variance and standard deviation

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**Measuring Risk Histogram of Annual Stock Market Returns # of Years**

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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.” 18

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Measuring Risk 19

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Measuring Risk 20

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Measuring Risk 21

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Portfolio Risk The variance of a two stock portfolio is the sum of these four boxes 19

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**Portfolio Risk Example**

Suppose you invest 65% of your portfolio in Coca-Cola and 35% in Reebok. The expected dollar return on your CC is 10% x 65% = 6.5% and on Reebok it is 20% x 35% = 7.0%. The expected return on your portfolio is = 13.50%. Assume a correlation coefficient of 1. 19

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**Portfolio Risk Example**

Suppose you invest 65% of your portfolio in Coca-Cola and 35% in Reebok. The expected dollar return on your CC is 10% x 65% = 6.5% and on Reebok it is 20% x 35% = 7.0%. The expected return on your portfolio is = 13.50%. Assume a correlation coefficient of 1. 19

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**Portfolio Risk Example**

Suppose you invest 65% of your portfolio in Coca-Cola and 35% in Reebok. The expected dollar return on your CC is 10% x 65% = 6.5% and on Reebok it is 20% x 35% = 7.0%. The expected return on your portfolio is = 13.50%. Assume a correlation coefficient of 1. 19

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Portfolio Risk 19

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**Portfolio Risk To calculate portfolio variance add up the boxes**

The shaded boxes contain variance terms; the remainder contain covariance terms. 1 2 3 4 5 6 N To calculate portfolio variance add up the boxes STOCK STOCK

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**Copyright 1996 by The McGraw-Hill Companies, Inc**

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

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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.

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Beta and Unique Risk

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Beta and Unique Risk Covariance with the market Variance of the market

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