Fundamentals of

Chapter 10 Corporate Finance

Fourth Edition

Introduction to
Risk, Return, and
the Opportunity
Cost of Capital
Slides by
Matthew Will

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 10- 2

Topics Covered

Rates of Return
A Century of Capital Market History
Measuring Risk
Risk & Diversification
Thinking About Risk

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 10- 3

Rates of Return

C a p ita l G a in + D iv id e n d
P e rc e n ta g e R e tu rn = In itia l S h a re P ric e

Percentage Return = 6 +430.56

= .153 or 15.3%

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 10- 4

Rates of Return

D iv id e n d Y ie ld = D iv id e n d
In itia l S h a re P ric e

C a p ita l G a in
C a p ita l G a in Y ie ld = In itia l S h a re P ric e

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 10- 5

Rates of Return
0.56
Dividend Yield =
43
 .013 or 1.3%

6
Capital Gain Yield =
43
 .140 or 14.0%
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 10- 6

Rates of Return
Nominal vs. Real

1 + real ror = 1 + nominal ror

1 + inflation rate

1 + real ror = 1 + .153

1 + .028  1.222
real ror  22.2%
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 10- 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.

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 10- 8

The Value of an Investment of $1 in 1900

1000
Common Stocks
Long T-Bonds
T-Bills
Index

10

0.1
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

Source: Ibbotson Associates Year End

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 10- 9

Rates of Return
Common Stocks (1900-2001)
60

40

20
Return (%)

-20

-40

-60
1936
1943

1971

1978
1985

1992
1999
1901

1908
1915
1922
1929

1950
1957

1964

Year

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 10- 10

Expected Return

Expected market interest rate on normal risk

= +
return Treasury bills premium

(1981) 21.7% = 14 + 7.7

(2002) 9.5% = 1.8 + 9.3

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 10- 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.

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 10- 12

Measuring Risk
Coin Toss Game-calculating variance and standard deviation

(1) (2) (3)

Percent Rate of Return Deviation from Mean Squared Deviation
+ 40 + 30 900
+ 10 0 0
+ 10 0 0
- 20 - 30 900
Variance = average of squared deviations = 1800 / 4 = 450
Standard deviation = square of root variance = 450 = 21.2%

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 10- 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.”

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 10- 14

Risk and Diversification

Deviation from Squared

Year Rate of Return Average Return Deviation
1997 31.29 20.01 400.45
1998 23.43 12.15 147.65
1999 23.56 12.28 150.78
2000 -10.89 -22.17 491.69
2001 -10.97 -22.25 495.24
Total 56.41 1685.81
Average rate of return = 56.41/5 = 11.28
Variance = average of squared deviations = 1685.81/5 = 337.16
Standard deviation = squared root of variance = 18.36%

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 10- 15

Risk and Diversification

Portfolio rate
of return (
=
fraction of portfolio
in first asset
x
)( rate of return
on first asset )
+
( fraction of portfolio
in second asset )( x
rate of return
on second asset )

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 10- 16

Stock Market Volatility 1926-2001

60

50

40
Std Dev

30

20

10

0
40

70
75

85

95
00
26
35

45
50
55
60
65

80

90
19
19
19
19
19
19
19
19
19
19
19
19
19
19
20
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 10- 17

Risk and Diversification

Portfolio standard deviation

0
5 10 15
Number of Securities

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 10- 18

Risk and Diversification

Portfolio standard deviation

Unique
risk

Market risk
0
5 10 15
Number of Securities

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 10- 19

Web Resources
Click to access web sites
Internet connection required

http://pages.stern.nyu/~adamodar
www.globalfindata.com

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