Book Review 2 - Book Outlines Prelim 2 Chs 10, 11, 13, 14,...

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Book Outlines – Prelim 2 Chs 10, 11, 13, 14, 21, 23 Chapter 10: Introduction to Risk, Return, and the Opportunity Cost of Capital I. Rates of Return: A Review a. When investors buy a stock or bond, their return comes in two forms i. Dividend/interest payment ii. Capital gain or capital loss b. Percentage return can also be expressed as the sum of the dividend yield and percentage capital gain c. Nominal return measures how much more money you will have at the end of the year if you invest today d. Real return tells you how much more you will be able to buy with your money at the end of the year II. A Century of Capital Market History a. Market Indexes i. Market indexes summarize the return on different classes of securities; they are a measure of the investment performance of the overall market ii. The Dow Jones Industrial Average is the best-known stock market index; it tracks the performance of a portfolio that holds one share in each of 30 large firms iii. The Standard & Poor’s Composite Index includes the stocks of 500 major companies and is therefore amore comprehensive index than the Dow. 1. S&P also measures the performance of a portfolio that holds shares in each firm in proportion to the number of shares that have been issued to investors 2. The companies represented in S&P 500 are among the largest in the country and account for nearly 80 percent of stocks traded b. The Historical Record i. A comparison was made between performance of 3-month Treasury Bills, 10-year Treasury Bonds, and a diversified portfolio of common stocks ii. Treasury bills are about as safe an investment as you can make iii. Treasury bonds are certain to be repaid when they mature, but the prices of these bonds fluctuate more as interest rates very 1. When interest rates fall, the value of long-term bonds rises; when rates rise, the value of the bonds falls iv. Common stocks are the riskiest because there is no promise you will get your money back—they also offer the greatest gains v. The difference in return between Treasury bonds and Treasury bills is called the maturity premium vi. The compensation for taking on the risk of common stock ownership is known as the market risk premium 1. Rate of return on common stocks = interest rate on Treasury bills + market risk premium
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vii. The historical record shows that investors have received a risk premium for holding risky assets. Average returns on high-risk assets are higher than those on low risk assets. viii. Bond prices also fluctuate, but far less so than stock prices c. Using Historical Evidence to Estimate Today’s Cost of Capital i. An investment project that you know has the same risk as an investment in a diversified portfolio of US common stocks has the same degree of risk as the market portfolio ii. Thus, the opportunity cost of capital for your project is the return that the shareholders could expect to earn on the market portfolio iii. It is impossible to estimate the expected market return based on
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This note was uploaded on 05/07/2008 for the course H ADM 222 taught by Professor Qma during the Spring '07 term at Cornell University (Engineering School).

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Book Review 2 - Book Outlines Prelim 2 Chs 10, 11, 13, 14,...

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