1. Introduction to Risk, Return, and the Opportunity Cost of Capital
Chapter 10
Fundamentals of
Corporate
Finance
Fifth Edition
Introduction to Risk, Return, and the Opportunity Cost of Capital
Slides by
Matthew Will
McGraw-Hill/Irwin
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved 1 1 1 1 2 1

2. Topics Covered Rates of Return: A Review
A Century of Capital Market History
Measuring Risk
Risk & Diversification
Thinking About Risk 2

3. Rates of Return 5

4. Rates of Return 6

5. Rates of Return 8

6. Rates of Return
Nominal vs. Real 11

7. Market Indexes Dow Jones Industrial Average (The Dow)
Value of a portfolio holding one share in each of 30 large industrial firms.
Standard & Poor’s Composite Index (The S&P 500)
Value of a portfolio holding shares in 500 firms. Holdings are proportional to the number of shares in the issues. 12

8. The Value of an Investment of $1 in 1900
$17,545
Index
$160
$61
2004
Year End
Source: Ibbotson Associates 13

9. Rates of Return
Common Stocks ( )
2004

10. Expected Return 15

11. 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. 16

12. Measuring Risk
Coin Toss Game-calculating variance and standard deviation 17

13. Risk and Diversification
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

14. Risk and Diversification

15. Risk and Diversification19

16. Stock Market Volatility 1926-2004
Std Dev
2004

17. Country Risk Premia (%)

18. Histogram of Returns

19. Risk and Diversification20

20. Risk and Diversification21

21. Thinking About Risk Message 1 Message 2
Some Risks Look Big and Dangerous but Really Are Diversifiable
Message 2
Market Risks Are Macro Risks