1.  Introduction to Risk, Return, and the Opportunity Cost of Capital Principles of Corporate Finance Brealey and Myers Sixth Edition Slides by Matthew Will Chapter 7 © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill

2. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 7- 2 Topics Covered  72 Years of Capital Market History  Measuring Risk  Portfolio Risk  Beta and Unique Risk  Diversification

3. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 7- 3 The Value of an Investment of $1 in 1926 Source: Ibbotson Associates Index Year End 1 5520 1828 55.38 39.07 14.25

4. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 7- 4 The Value of an Investment of $1 in 1926 Source: Ibbotson Associates Index Year End 1 613 203 6.15 4.34 1.58 Real returns

5. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 7- 5 Rates of Return 1926-1997 Source: Ibbotson Associates Year Percentage Return

6. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 7- 6 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.

7. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 7- 7 Measuring Risk Coin Toss Game-calculating variance and standard deviation

8. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 7- 8 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.”

9. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 7- 9 Measuring Risk

10. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 7- 10 Measuring Risk

11. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 7- 11

12. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 7- 12 Portfolio Risk The variance of a two stock portfolio is the sum of these four boxes:

13. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 7- 13 Portfolio Risk

14. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 7- 14 Portfolio Risk The shaded boxes contain variance terms; the remainder contain covariance terms. 1 2 3 4 5 6 N 123456N STOCK To calculate portfolio variance add up the boxes

15. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 7- 15 Beta and Unique Risk beta Expected return Expected market return 10% -+ - 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.

16. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 7- 16 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.

17. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 7- 17 Beta and Unique Risk

18. © The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 7- 18 Beta and Unique Risk Covariance with the market Variance of the market