Cost of Capital

Cost of Capital - FINA537 Equity Valuation Professor Laura...

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1 FINA537 Equity Valuation Professor Laura Xiaolei Liu Cost of Capital – Risk and Return
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2 What is risk? Will I win??? $$$$$$
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3 What is risk? • Risk is the uncertainty about the outcome • Risk in the stock market is the uncertainty about the return you can get from purchasing a stock
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4 Calculating Rates of Return • Suppose you purchased a share of IBM common stock for $100 on January 1 2009, if the stock pays $4 in dividends, and if it has a market price of $108 on December 31, 2007 • The rate of return on this investment is r = 4 + 108 100 100 = 12%
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5 Rate of return on risky asset • What if the IBM price is $96 at Dec 31, 2009 r = (4 + 96 100)/100 = 0% What if the IBM price is $86 at Dec 31, 2009 r = (4 + 86 100)/100 = -10% What if the IBM go bankruptcy at Dec 31,2009 r = (0-100)/100 = -100% • Realized return depends on the stock price at Dec 31, it also depends on the dividend paid during the year 2009
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6 Calculating Rates of Return • Rates of return for most assets are random • Looking backward, we can calculate realized rates of return • Looking forward, we characterize random events with probabilities and probability distributions • Probability distributions are often described by summary measures like the mean and variance, the mean of this distribution is called expected return
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7 Rate of Return Distribution IBM monthly stock return (1980-2000) 0 10 20 30 40 -0.2 -0.1 0.0 0.1 0.2 Series: RET Sample 1 240 Observations 240 Mean 0.013393 Median 0.011645 Maximum 0.238180 Minimum -0.261900 Std. Dev. 0.074086 Skewness -0.067616 Kurtosis 3.528114 Jarque-Bera 2.971918 Probability 0.226285
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8 Return of risk-free asset • On January 1, 2009, you deposit $100 to the saving account of Hang Seng Bank, Hong Kong, which offers a 5% interest rate r = $105 $100 =5% 100 • You will receive 5% return no matter what happens (assuming the government will not allow the bank go bankruptcy for various of reasons). • It is risk-free
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9 Investor Preferences • We will make two fundamental assumptions about investor preferences ¾ Investors prefer more wealth to less ( other things equal, investors prefer higher expected returns) ¾ Investors are risk averse (other things equal, investors prefer a lower standard deviation of their wealth)
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10 Risk and Return • Since investors are risk-averse, they must be compensated for taking risk E(R s ) = R f + Risk Premium • Risk premium is higher if the stock is more risky • How to measure risk?
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11 Modern Portfolio Theory • Before Harry Markowitz pioneered portfolio theory, risk was usually measured by the stock return variance or stock-return standard deviation • Modern Portfolio theory points out that risk can be reduced by diversification
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12 Risk Reduction through Diversification Two firms located on an isolated Caribbean island Buy $100 of A, you get expected return of 12% with uncertainty, assuming there is equal choice to get sunny, normal or rainy day. Similarly for buying $100 of B 33% Rainy year 12% Normal year Disposable Umbrella Manufacture -9% Sunny year Company B -9% Rainy year 12% Normal year Suntan Lotion Manufacture 33% Sunny year Company A Return on Stock Weather Conditions
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13 Risk Reduction through Diversification
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This note was uploaded on 04/12/2010 for the course FINA 537 taught by Professor Luxiaolei during the Spring '09 term at HKUST.

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Cost of Capital - FINA537 Equity Valuation Professor Laura...

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