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Chapter 10
Risk–Return Tradeoff
-‐‑ Two key lessons from capital market history:
o There is a reward for bearing risk
o The greater the potential reward, the greater the risk
Dollar & Percent Returns
-‐‑ Total dollar return = the return on an investment measured in dollars
o $ Return = Dividends + Capital Gains
o Capital Gains = Price received – Price paid
-‐‑ Total percent return = the return on an investment measured as a
percentage of the original investment
...
Geometric Mean
-‐‑ Arithmetic average:
o Return earned in an average period over multiple periods
o Answers the question: “What was your return in an average year over
a particular period?”
-‐‑ Geometric average:
o Average compound return per period over multiple periods
o Answers the question: “What was your average compound return per
year over a particular period?”
-‐‑ Geometric average < arithmetic average unless all the returns are equal
Arithmetic vs
...
o If true, then investors cannot earn abnormal returns by trading on
public information
o Implies that fundamental analysis will not lead to abnormal returns
-‐‑ Weak Form Efficiency
o Prices reflect all past market information such as price and volume
o If true, then investors cannot earn abnormal returns by trading on
market information
o Implies that technical analysis will not lead to abnormal returns
o Empirical evidence indicates that markets are generally weak form
efficient
Common Misconceptions about EMH
-‐‑ EMH does not mean that you can’t make money
-‐‑ EMH does mean that:
o On average, you will earn a return appropriate for the risk undertaken
o There is no bias in prices that can be exploited to earn excess returns
o Market efficiency will not protect you from wrong choices if you do
not diversify – you still don’t want to put all your eggs in one basket
Chapter 11
Expected Returns
-‐‑ Expected returns are based on the probabilities of possible outcomes
Variance and Standard Deviation
-‐‑ Variance and standard deviation measure the volatility of returns
-‐‑ Variance = Weighted average of squared deviations
-‐‑ Standard Deviation = Square root of variance
Portfolios
-‐‑ Portfolio = collection of assets
-‐‑ An asset’s risk and return impact how the stock affects the risk and return of
the portfolio
-‐‑ The risk-‐‑return trade-‐‑off for a portfolio is measured by the portfolio
expected return and standard deviation, just as with individual assets
Portfolio Expected Returns
-‐‑ The expected return of a portfolio is the weighted average of the expected
returns for each asset in the portfolio
-‐‑ Weights (wj) = % of portfolio invested in each asset
Portfolio Risk Variance & Standard Deviation
-‐‑ Portfolio standard deviation is NOT a weighted average of the standard
deviation of the component securities’ risk
o If it were, there would be no benefit to diversification
...
Unsystematic Risk
-‐‑ = Diversifiable risk
-‐‑ Risk factors that affect a limited number of assets
-‐‑
-‐‑
-‐‑
-‐‑
Risk that can be eliminated by combining assets into portfolios
“Unique risk”
“Asset-‐‑specific risk”
Examples: labor strikes, part shortages, etc
...
Total Risk = Stand-‐‑alone Risk
-‐‑ Total risk = Systematic risk + Unsystematic risk
o The standard deviation of returns is a measure of total risk
-‐‑ For well-‐‑diversified portfolios, unsystematic risk is very small
o Total risk for a diversified portfolio is essentially equivalent to the
systematic risk
Systematic Risk Principle
-‐‑ There is a reward for bearing risk
-‐‑ There is no reward for bearing risk unnecessarily
-‐‑ The expected return (market required return) on an asset depends only on
that asset’s systematic or market risk
...
0, stock has average risk
-‐‑ If b > 1
...
0, stock is less risky than average
-‐‑ Most stocks have betas in the range of 0
...
5
-‐‑ Beta of the market = 1
...
0
The SML and Required Return
-‐‑ The Security Market Line (SML) is part of the Capital Asset Pricing Model
(CAPM)
-‐‑ Rf = Risk-‐‑free rate (T-‐‑Bill or T-‐‑Bond)
-‐‑ RM = Market return ≈ S&P 500
-‐‑ RPM = Market risk premium = E(RM) – Rf
-‐‑ E(Rj) = “Required Return of Asset j”
Capital Asset Pricing Model
-‐‑ The capital asset pricing model (CAPM) defines the relationship between risk
and return
-‐‑ If an asset’s systematic risk (b) is known, CAPM can be used to determine its
expected return
Chapter 12
Cost of Capital Basics
-‐‑ The cost to a firm for capital funding = the return to the providers of those
funds
o The return earned on assets depends on the risk of those assets
o A firm’s cost of capital indicates how the market views the risk of the
firm’s assets
o A firm must earn at least the required return to compensate investors
for the financing they have provided
o The required return is the same as the appropriate discount rate
Cost of Equity
-‐‑ The cost of equity is the return required by equity investors given the risk of
the cash flows from the firm
-‐‑ Two major methods for determining the cost of equity
o Dividend growth model
o SML or CAPM
Advantages and Disadvantages of Dividend Growth Model
-‐‑ Advantage – easy to understand and use
-‐‑ Disadvantages
o Only applicable to companies currently paying dividends
o Not applicable if dividends aren’t growing at a reasonably constant
rate
o Extremely sensitive to the estimated growth rate
o Does not explicitly consider risk
Advantages and Disadvantages of SML
-‐‑ Advantages
o Explicitly adjusts for systematic risk
o Applicable to all companies, as long as beta is available
-‐‑ Disadvantages
o Must estimate the expected market risk premium, which does vary
over time
o Must estimate beta, which also varies over time
o Relies on the past to predict the future, which is not always reliable
Cost of Debt
-‐‑ The cost of debt = the required return on a company’s debt
-‐‑ Method 1 = Compute the yield to maturity on existing debt
-‐‑ Method 2 = Use estimates of current rates based on the bond rating expected
on new debt
-‐‑ The cost of debt is NOT the coupon rate
Cost of Preferred Stock
-‐‑ Preferred pays a constant dividend every period
-‐‑ Dividends expected to be paid forever
-‐‑ Preferred stock is a perpetuity
Weighted Average Cost of Capital
-‐‑ Use the individual costs of capital to compute a weighted “average” cost of
capital for the firm
-‐‑ This “average” = the required return on the firm’s assets, based on the
market’s perception of the risk of those assets
-‐‑ The weights are determined by how much of each type of financing is used
Determining the Weights for the WACC
-‐‑ Weights = percentages of the firm that will be financed by each component
-‐‑ Always use the target weights, if possible
o If not available, use market values
Capital Structure Weights
-‐‑ Notation
o E = market value of equity
= # outstanding shares times price per share
o D = market value of debt
= # outstanding bonds times bond price
o V = market value of the firm = D + E
-‐‑ Weights
o E/V = percent financed with equity
o D/V = percent financed with debt
Factors that Influence a Company’s WACC
-‐‑ Market conditions, especially interest rates, tax rates and the market risk
premium
-‐‑ The firm’s capital structure and dividend policy
-‐‑ The firm’s investment policy
o Firms with riskier projects generally have a higher WACC
Risk-‐‑Adjusted WACC
-‐‑ A firm’s WACC reflects the risk of an average project undertaken by the firm
o “Average” Æ risk = the firm’s current operations
-‐‑ Different divisions/projects may have different risks
o The division’s or project’s WACC should be adjusted to reflect the
appropriate risk and capital structure
Pure Play Approach
-‐‑ Find one or more companies that specialize in the product or service being
considered
-‐‑ Compute the beta for each company
-‐‑ Take an average
-‐‑ Use that beta along with the CAPM to find the appropriate return for a
project of that risk
-‐‑ Pure play companies can be difficult to find
Subjective Approach
-‐‑ Consider the project’s risk relative to the firm overall
o If the project is riskier than the firm, use a discount rate greater than
the WACC
o If the project is less risky than the firm, use a discount rate less than
the WACC