1. Intro to Financial Management Risk and Return

2. Review Homework What is “the time value of money?” How do you calculate and what do these ratios mean? –Current ratio –Acid-test –Inventory turnover –ROS, Return on sales –ROA, Return on assets –ROE, Return on equity –Debt ratio –Leverage ratio –P/E

3. Review How do you calculate and what do these ratios mean? –Current ratio –Acid-test –Accounts receivable turnover –Inventory turnover –Operating return on assets –Operating profit margin –Asset turnover –Accounts receivable turnover –Debt ratio –Leverage ratio –ROE –P/E

4. Returns Holding period –Return –Rate of return Expected cash flow –Weighted average of all possible cash flows –Deal or No Deal Expected rate of return –Weighted average of all possible returns –E.g. 90% probability of getting $1, 10% probability of $0 –Use ̅ r

5. Risk Clearly important –What is it? –If it’s important, we need to measure it “What defines modern times is the mastery of risk” In finance, risk is the standard deviation of future returns –Other measures have been tried –Note that standard deviation includes upside risk –Most investors only care about downside risk (behavioral) –σ = sqrt( Ʃ (r i - ̅ r ) 2 * P(r i ) ) Compare two different investments –T-bill at 4% –Stock with range of returns

6. Investors’ Risk and Return

7. Risk – By Asset Class Worst Annual Return Since 1925 Average Annual Return Since 1925 Stocks -43.4% (-67.6% worst 12 mo.) 9.6% (162.9% best 12 mo.) Bonds-7.8%5.5% Cash.1%3.7% Sources: personal.fidelity.com, Morgan Stanley, www.efficientfrontier.com, Federal Reserve – St. Louis

8. Investors’ Risk and Return

9. Not All Risk is the Same Firm Risk = Systemic risk + Idiosyncratic Risk Business Cycles Financial Markets Global Conditions Risk Unique to the Firm Source of Correlation Idiosyncratic risk can be diversified away!

10. Diversification – Simple Example IBM and AT&T When IBM went down, AT&T went up. When AT&T went down, IBM went up. If stocks are perfectly positively correlated, diversification has no effect on risk If stocks are perfectly negatively correlated, portfolio is perfectly diversified. What do you want as an investor?

11. Risk and Diversification With large portfolio, 30 – 200 stocks, idiosyncratic moves cancel out!

12. Market Risk Have to decide what the “market” is. –DJIA? –S&P 500? Pick a benchmark Calculate holding period returns for the benchmark Calculate holding period returns for investment Compare them

13. Characteristic Line Source: Wikipedia, characteristic line. Note: the slope is the change in portfolio divided by the change in the market – beta β Characteristic line is the best fit line for the points.

14. Beta Measures the relationship between an investment’s returns and the market’s returns Beta is the risk that is left after having diversified the portfolio Interpreting beta –< 1 less risk than the market. When the market goes up (down), the investment goes up (down) to a smaller degree –= 1 same risk as the market –> 1 more risk than the market. When the market goes up (down), the investment goes up more (less) to a greater degree

15. Understanding Beta Rank the beta of these companies –Walmart –Ford –McDonalds –Bank of America –AT&T –JP Morgan –Apple –Microsoft

16. Understanding Beta Rank the beta of these companies –Walmart.36 –McDonalds.46 –AT&T.60 –Apple.82 –Microsoft.99 –JP Morgan1.24 –Bank of America2.19 –Ford2.37 Source: finance/yahoo.com Jan. 16, 2012

17. Calculating Portfolio Beta  portfolio = Σ w j *  j Where w j = % invested in stock  I = Beta of stock j

18. Asset Allocation How investor spreads portfolio across investments Single biggest determinate of investment results

19. Required Rate of Return Minimum rate of return necessary to attract an investor –Includes opportunity cost of next best investment Require rate of return = risk-free rate of return + risk premium Use U.S. Treasury Bill rate as risk-free rate Risk premium is the return we require for taking risk

20. Capital Asset Pricing Model (CAPM) Beta is the determinate of required returns r f is the rate of U.S. T-Bills (known) r m is the market return (known) r is then determined by β

21. CAPM Examples Risk-free rate =.02% Market risk = 9% What is required rate of return if beta = 0, 1, 2? What if the risk-free rate rises to 4%? What if the market risk = 12%?

22. Security Market Line Graph of the CAPM