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Week 1 Lecture

# Week 1 Lecture - Corporate Finance II Lecture Cost of...

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Corporate Finance II Lecture : Cost of Capital: Risk vs. Return

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Part I: Review of the FINC2001 Material Review of Previous Unit Part I: Review of the FINC2011 Material 1 Summary of the FINC2011 Material Topics
Previous Unit Topics FINC2011’s topics. Financial mathematics. Ø Future value, present value, compounding interest Ø Annuities, perpetuities Capital Asset Pricing Model (CAPM). Ø Capital Market Line (CML) Ø Security Market Line (SML) Ø Systematic risk, Beta, diversifiable risk Capital budgeting, company cost of capital Market efficiency

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Part II Today: Cost of Capital: Risk vs. Return
Lecture Summary: Outline of Today’s Lecture 1 Introduction 2 The Problem 3 Measuring Returns : Arithmetic & Geometric Average 4 Measuring Risk : Variance (Standard Deviation) 5 A Recap of Variance and Covariance 6 How Securities Affect Portfolios 7 Risk and Return in Portfolios 8 The Relationship Between Risk and Return A CAPM Example

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We have securities that entitle you to future cashflows: Ø What is the value of these securities? Companies “issue” or sell securities Ø Company value is the value of the securities it has issued Individuals “acquire” or buy securities Ø Individual wealth is the value of the securities they have bought/ invested in
The Problem The above is a generalization . . . Ø Companies and individuals can buy and sell securities Note For ALL securities. Price =PV [Expected future cashflows], = E[ futurecashflows ] discount factor Different models (usually some equation(s)) make different assumptions about: 1 The future cashflows, e.g. magnitude and timing 2 The probability associated with each future cashflow. 3 The present value calculation - the discount rate.

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The Problem Prices affect the values of companies and individuals. From prices we move easily to returns: r 1 = P 1 − P 0 P 0 P 1 = Price at time 1 P 0 = Price at time 0 Ø Say you own 100 shares worth \$10 each, then Wealth = \$1000
The Problem Returns can be: 1 Backward looking

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