chapter6 - Chapter Six Risk and Return MGMT 109 Managerial...

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1 Chapter Six Risk and Return MGMT 109 Managerial Finance Professor Lu Zheng Motivation • The goal of financial management is to maximize the value of a firm by taking positive NPV projects. • The NPV of a project is determined by project cash flows and project cost of capital. • Our goal is to develop a theory of risk and return so that we can estimate the cost of capital. • The cost of capital measures the expected return on other investments with similar risk. About Risk There are two times in a man's life when he should not speculate: when he can't afford it and when he can. [Mark Twain, Following the Equator]
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2 Percentage Returns $41.25 $1.25 $40 Total Dividends Ending market value t = 1 t – $35 Time Percentage Returns Dividends paid at Change in market end of period value over period Percentage return = Beginning market value = Dividend yield + Capital gains yield + Example – Calculating Returns • You bought a stock for $35 and you received dividends of $1.25. The stock is now selling for $40. – What is your dollar return? • Dollar return = 1.25 + (40 – 35) = $6.25 – What is your percentage return? • Dividend yield = 1.25 / 35 = 3.57% • Capital gains yield = (40 – 35) / 35 = 14.29% • Total percentage return = 3.57 + 14.29 = 17.86%
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3 More Concepts • Assets: anything with future cash flow consequences • Portfolios: a collection of assets. – To define a portfolio, we need to know the assets and their weights Statistical Concepts of Risk and Return • Expected Return •V a r i a n c e • Standard Deviation Calculating the Expected Return s E(R) = ( p i x r i ) i =1 p i r i Probability Return in State of Economy of state i state i +1% change in GNP .25 -5% +2% change in GNP .50 15% +3% change in GNP .25 35% Σ i( p i x r i ) i = 1 -1.25% i = 2 7.50% i = 3 8.75% Expected return = (-1.25 + 7.50 + 8.75) = 15%
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4 Calculating the Variance and Standard Deviation s Var(R) = σ 2 = [ p i * ( r i E(R) ) 2 ] i =1 i r iE ( R ) (r i – E(R)) 2 p i x (r i –E(R) ) 2 i=1 -5% 15% .04 .01 i=2 15% 15% 0 0 i=3 35% 15% .04 .01 Var(R) = .02 What is the standard deviation? σ = (var)^0.5 = 0.1414 Topics Covered • Capital Market History • Measuring Risk • Portfolio Risk • Diversification The Importance of Financial Markets • Financial markets allow companies, governments and individuals to increase their utility – Savers have the ability to invest in financial assets so that they can defer consumption and earn a return to compensate them for doing so – Borrowers have better access to the capital that is available so that they can invest in productive assets • Financial markets also provide us with information about the returns that are required for various levels of risk
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5 The Value of an Investment of $1 in 1926 0.1 10 1000 1925 1940 1955 1970 1985 2000 S&P Small Cap Corp Bonds Long Bond T Bill Source: Ibbotson Associates Index Year End 1 660 267 6.6 5.0 1.7 Real returns The Value of an Investment of $1 in 1926 Rates of Return 1926-2000 Source: Ibbotson Associates -60 -40 -20 0 20
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This note was uploaded on 01/17/2011 for the course MGMT 107 taught by Professor ? during the Winter '08 term at UC Irvine.

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chapter6 - Chapter Six Risk and Return MGMT 109 Managerial...

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