FM14e PPT Ch06
FM14e PPT Ch06
FM14e PPT Ch06
Financial
Management:
Theory and Practice
14e
1
CHAPTER 6
Risk and Return
Topics in Chapter
Required investments
in operating capital
Value =
FCF1
FCF2
+
(1 + WACC)1 (1 + WACC)2
+
...
FCF
+
(1 +
WACC)
Weighted average
cost of capital
(WACC)
Market interest rates
Market risk aversion
Cost of debt
Cost of equity
Dollar terms.
Percentage terms.
5
= $60.
Percentage return:
$ Return/$ Invested
$60/$1,000
= 0.06 = 6%.
6
Scenarios and Returns for the 10Year Zero Coupon T-bond Over the
Next Year
Scenari Probabilit
o
y
Return
Worst
0.10
Case
14%
Poor Case
0.20
4%
Most
0.40
6%
Likely
Good
0.20
16%
Case
Best Case
0.10
26%
8
Discrete Probability
Distribution for Scenarios
0.4
0.3
Probability
0.2
0.1
0.0
-0.14000000000000001
0.06
0.26
Returns
9
Example of a Continuous
Probability Distribution
-30%
-20%
-10%
0%
10%
20%
30%
Returns
10
40%
= 0.10(-14%) + 0.20(-4%) +
0.40(6%)
+ 0.20(16%) + 0.10(26%)
= 6%
11
= SUMPRODUCT(Probabilities,Returns)
SUMPRODUCT:
Multiplies each value in the first array (the
range of cells with probabilities) by its
corresponding value in the second array
(the range of cells with returns).
Sums the products.
This is identical to the formula on the
previous slide.
See Ch06 Mini Case.xls
12
-30%
-20%
-10%
0%
10%
20%
30%
Return
13
40%
Stand-Alone Risk:
Standard Deviation
14
15
=
= 0.1095 = 10.95%
16
SUMPRODUCT(Probabilities,Returns ,Returns)
SUMPRODUCT:
Multiplies each value in the first array (the
range of cells with probabilities) by its
corresponding value in the second array (the
range of cells with returns less the expected
return) and by the third array (which is
identical to the second array).
Sums the products; the result is variance.
Take the square root of the variance to get the
standard deviation. See Ch06 Mini Case.xls
17
Understanding the
Standard Deviation
Useful in Comparing
Investments
21
22
=AVERAGE(SampleData)
=STDEV(SampleData)
23
Market
Blandy
Gourmange
30%
26%
47%
15
54
18
14
15
22
15
14
28
10
18
40
26
42
17
10
30
23
32
10
38
28
75
24
Average return
Standard
deviation
Market
8.0%
Blandy
6.4%
20.1%
25.2%
Gourmange
9.2%
38.6%
25
Assumptions:
< 18.8%
(6.4%25.2% = 18.8%)
> 31.6%
(6.4%+25.2% = 31.6%)
Stocks are very risky!
26
Portfolio Returns
The
percentage of a portfolios
value that is invested in Stock i is
denoted by the weight wi. Notice
that the sum of all the weights
must equal 1.
With n stocks in the portfolio, its
return each year will be:
27
Form
a portfolio by selling 25% of
the Blandy stock and investing it in
the higher-risk Gourmange stock.
The portfolio return each year will
be:
28
Blandy
Gourmange
Portfolio of Blandy
and Gourmange
26%
47%
31.3%
15
54
2.3
14
15
6.8
15
9.5
28
5.5
18
40
3.5
42
17
35.8
30
23
16.8
32
25.0
10
28
75
39.8
29
Portfolio
e
Average return
Standard
6.4%
9.2%
38.6%
7.1%
30
22.2%
-25%
-50%
-75%
Year
9 10
Loosely
speaking, the correlation ()
32
2-Stock Portfolios
= 1
= +1
1 < < 1
Adding Stocks to a
Portfolio
Company Specific
(Diversifiable) Risk
Total Portfolio Risk, p
20%
Market Risk
0
10 20 30 40
2,000 stocks
36
Conclusions
Define:
41
The
beta of Stock i (bi) is defined:
bi =
The contribution of Stock i to the standard
deviation of a well-diversified portfolio ( p) is:
wi M bi
Given the standard deviation of the market
and the percent of the portfolio invested in
Stock i, beta measures the impact of
Stock i on p.
42
RPM = rM rRF.
RPi = bi (RPM)
44
45
Correlation Between
Blandy and the Market
B,M = 0.481
47
b = B,M (B/M)
b = 0.481(.252/.201) = 0.60
Inputs:
rRF = 4% (given)
RPM = 5% (given)
b = 0.60 (estimated)
ri = rRF + bi (RPM)
ri = 4% + 0.60(5%) = 7%
49
Using a Regression to
Estimate Beta
0.45
0.45
Market
Returns
-0.45
52
y = 0.6027x + 0.0158
b = Slope = 0.6027 (same as before)
b =SLOPE(y_values,x_values)
53
http://finance.yahoo.com
www.valueline.com
0.0
0.5
1.0
1.5
2.0
2.5
Beta
55
Required
Return
10%
5%
0%
0.0
0.5
1.0
1.5
2.0
2.5
Beta
56
wB = $1.4/($1.4+$0.6) = 70%
wG = $0.6/($1.4+$0.6) = 30%
57
58
Portfolio Performance
Evaluation Relative to SML
Portfolio Manager
JJ
CC
Portfolio beta
0.7
1.4
Risk-free rate
4%
4%
Market risk premium
5%
5%
Portfolio required return
7.5%
11.0%
Portfolio actual return
8.5%
9.5%
Over/under
+1.0%
1.5%
performance
60
Performance Relative to
the SML
16%
14%
12%
10%
8%
Required Return
6%
4%
2%
0%
0.5
1.5
2.5
Beta
61
All Relevant
Available
Information
Unbiased
Expected Future
Cash Flows
Unbiase
d Risk
Intrinsic Value
Selected Information
and Its
Interpretation
Perceived Future
Cash Flows
Equal
?
Perceived
Risk
Market Price
The
market price of a security must equal
How is equilibrium
established?
66
Weak-form EMH
Short-term momentum
Long-term reversals
69
Semistrong-form EMH
Semistrong-form EMH:
Empirical Evidence
Small companies
Companies with high book-to-market ratios
71
Strong-form EMH
Market bubbles:
Market Efficiency:
The Bottom Line
The CAPM:
The Bottom Line