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Lecture Intermediate corporate finance – Chapter 2: Risk and return (Part I)

Lecture Intermediate corporate finance – Chapter 2: Risk and return (Part I). This chapter presents the following content: Basic return concepts, basic risk concepts, stand-alone risk, portfolio (market) risk, risk and return: CAPM/SML. | CHAPTER 2 Risk and Return: Part I Topics in Chapter Basic return concepts Basic risk concepts Stand-alone risk Portfolio (market) risk Risk and return: CAPM/SML 1 What are investment returns? Investment returns measure the financial results of an investment. Returns may be historical or prospective (anticipated). Returns can be expressed in: Dollar terms. Percentage terms. An investment costs $1,000 and is sold after 1 year for $1,100. Dollar return: Percentage return: $ Received - $ Invested $1,100 - $1,000 = $100. $ Return/$ Invested $100/$1,000 = 0.10 = 10%. 2 What is investment risk? Typically, investment returns are not known with certainty. Investment risk pertains to the probability of earning a return less than that expected. The greater the chance of a return far below the expected return, the greater the risk. 2 Probability Distribution: Which stock is riskier? Why? Consider the Following Investment Alternatives Econ. Prob. T-Bill Alta Repo Am F. MP Bust 0.10 8.0% -22.0% 28.0% 10.0% -13.0% Below avg. 0.20 8.0 -2.0 14.7 -10.0 1.0 Avg. 0.40 8.0 20.0 0.0 7.0 15.0 Above avg. 0.20 8.0 35.0 -10.0 45.0 29.0 Boom 0.10 8.0 50.0 -20.0 30.0 43.0 1.00 What is unique about the T-bill return? The T-bill will return 8% regardless of the state of the economy. Is the T-bill riskless? Explain. 5 Alta Inds. and Repo Men vs. the Economy Alta Inds. moves with the economy, so it is positively correlated with the economy. This is the typical situation. Repo Men moves counter to the economy. Such negative correlation is unusual. 7 Calculate the expected rate of return on each alternative. r = expected rate of return. rAlta = 0.10(-22%) + 0.20(-2%) + 0.40(20%) + 0.20(35%) + 0.10(50%) = 17.4%. ^ ^ n ∑ r = ^ i=1 riPi. Alta has the highest rate of return. Does that make it best? ^ r Alta 17.4% Market 15.0 Am. Foam 13.8 T-bill 8.0 Repo Men 1.7 What is the standard deviation of returns for each alternative? σ = Standard deviation σ = √ Variance | CHAPTER 2 Risk and Return: Part I Topics in Chapter Basic return concepts Basic risk concepts Stand-alone risk Portfolio (market) risk Risk and return: CAPM/SML 1 What are investment returns? Investment returns measure the financial results of an investment. Returns may be historical or prospective (anticipated). Returns can be expressed in: Dollar terms. Percentage terms. An investment costs $1,000 and is sold after 1 year for $1,100. Dollar return: Percentage return: $ Received - $ Invested $1,100 - $1,000 = $100. $ Return/$ Invested $100/$1,000 = 0.10 = 10%. 2 What is investment risk? Typically, investment returns are not known with certainty. Investment risk pertains to the probability of earning a return less than that expected. The greater the chance of a return far below the expected return, the greater the risk. 2 Probability Distribution: Which stock is riskier? Why? Consider the Following Investment Alternatives Econ. Prob. T-Bill Alta Repo Am F. MP Bust