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Principles of Corporate Finance Seventh Edition Richard A. Brealey Stewart C. Myers Slides by Matthew Will Chapter 7 McGraw Hill/Irwin Copyright © 2003.

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Presentation on theme: "Principles of Corporate Finance Seventh Edition Richard A. Brealey Stewart C. Myers Slides by Matthew Will Chapter 7 McGraw Hill/Irwin Copyright © 2003."— Presentation transcript:

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

2 7- 2 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Topics Covered 75 Years of Capital Market History Measuring Risk Portfolio Risk Beta and Unique Risk Diversification

3 7- 3 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved The Value of an Investment of $1 in 1926 Source: Ibbotson Associates Index Year End

4 7- 4 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Source: Ibbotson Associates Index Year End Real returns The Value of an Investment of $1 in 1926

5 7- 5 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Rates of Return Source: Ibbotson Associates Year Percentage Return

6 7- 6 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Average Market Risk Premia ( ) Risk premium, % Country

7 7- 7 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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.

8 7- 8 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Measuring Risk Coin Toss Game-calculating variance and standard deviation

9 7- 9 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Measuring Risk Return % # of Years Histogram of Annual Stock Market Returns

10 7- 10 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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.

11 7- 11 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Measuring Risk

12 7- 12 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Measuring Risk

13 7- 13 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Measuring Risk

14 7- 14 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Portfolio Risk The variance of a two stock portfolio is the sum of these four boxes

15 7- 15 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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.

16 7- 16 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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.

17 7- 17 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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.

18 7- 18 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Portfolio Risk

19 7- 19 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Portfolio Risk The shaded boxes contain variance terms; the remainder contain covariance terms N N STOCK To calculate portfolio variance add up the boxes

20 7- 20 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Beta and Unique Risk beta Expected return Expected market return 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

21 7- 21 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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 stocks return to the return on the market portfolio.

22 7- 22 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Beta and Unique Risk

23 7- 23 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Beta and Unique Risk Covariance with the market Variance of the market


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