1. 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

2. Topics Covered 75 Years of Capital Market History Measuring Risk
Portfolio Risk
Beta and Unique Risk
Diversification

3. 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

4. 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

5. Rates of Return 1926-2000 Percentage Return Year
Source: Ibbotson Associates 14

6. Average Market Risk Premia (1999-2000)
Risk premium, %
Country

7. 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. Measuring Risk
Coin Toss Game-calculating variance and standard deviation

9. Measuring Risk Histogram of Annual Stock Market Returns # of Years

10. 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

11. Measuring Risk 19

12. Measuring Risk 20

13. Measuring Risk 21

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

15. 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

16. 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

17. 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

18. Portfolio Risk 19

19. 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

20. 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%

21. 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.

22. Beta and Unique Risk

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