Principles of Corporate Finance Brealey and Myers Sixth

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

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

7 - 3 The Value of an Investment of $1 in 1926 5520 1828 Index 55. 38 39. 07 14. 25 1 Source: Ibbotson Associates Irwin/Mc. Graw Hill Year End ©The Mc. Graw-Hill Companies, Inc. , 2000

7 - 4 The Value of an Investment of $1 in 1926 Real returns 613 Index 203 6. 15 4. 34 1 Source: Ibbotson Associates Irwin/Mc. Graw Hill 1. 58 Year End ©The Mc. Graw-Hill Companies, Inc. , 2000

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

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. Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000

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

7 - 8 Measuring Risk Histogram of Annual Stock Market Returns # of Years Return % Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000

7 - 9 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. ” Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000

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

7 - 11 Irwin/Mc. Graw Hill Measuring Risk ©The Mc. Graw-Hill Companies, Inc. , 2000

7 - 12 Irwin/Mc. Graw Hill Measuring Risk ©The Mc. Graw-Hill Companies, Inc. , 2000

7 - 13 Portfolio Risk The variance of a two stock portfolio is the sum of these four boxes: Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000

7 - 14 Portfolio Risk Example Suppose you invest $55 in Bristol-Myers and $45 in Mc. Donald’s. The expected dollar return on your BM is. 10 x 55 = 5. 50 and on Mc. Donald’s it is. 20 x 45 = 9. 90. The expected dollar return on your portfolio is 5. 50 + 9300 = 14. 50. The portfolio rate of return is 14. 50/100 =. 145 or 14. 5%. Assume a correlation coefficient of 1. Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000

7 - 15 Portfolio Risk Example Suppose you invest $55 in Bristol-Myers and $45 in Mc. Donald’s. The expected dollar return on your BM is. 10 x 55 = 5. 50 and on Mc. Donald’s it is. 20 x 45 = 9. 90. The expected dollar return on your portfolio is 5. 50 + 9300 = 14. 50. The portfolio rate of return is 14. 50/100 =. 145 or 14. 5%. Assume a correlation coefficient of 1. Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000

7 - 16 Portfolio Risk Example Suppose you invest $55 in Bristol-Myers and $45 in Mc. Donald’s. The expected dollar return on your BM is. 10 x 55 = 5. 50 and on Mc. Donald’s it is. 20 x 45 = 9. 90. The expected dollar return on your portfolio is 5. 50 + 9300 = 14. 50. The portfolio rate of return is 14. 50/100 =. 145 or 14. 5%. Assume a correlation coefficient of 1. Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000

7 - 17 Irwin/Mc. Graw Hill Portfolio Risk ©The Mc. Graw-Hill Companies, Inc. , 2000

7 - 18 Portfolio Risk The shaded boxes contain variance terms; the remainder contain covariance terms. 1 2 3 STOCK To calculate portfolio variance add up the boxes 4 5 6 N 1 2 3 4 5 6 N STOCK Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000

7 - 19 Beta and Unique Risk 1. Total risk = diversifiable risk + market risk 2. Market risk is measured by beta, the sensitivity to market changes. Expected stock return beta +10% - 10% +10% -10% Expected market return Copyright 1996 by The Mc. Graw-Hill Companies, Inc Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000

7 - 20 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. Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000

7 - 21 Irwin/Mc. Graw Hill Beta and Unique Risk ©The Mc. Graw-Hill Companies, Inc. , 2000

7 - 22 Beta and Unique Risk Covariance with the market Variance of the market Irwin/Mc. Graw Hill ©The Mc. Graw-Hill Companies, Inc. , 2000