Chapter 07 Financial Management

Chapter 07 Financial Management - Financial Management ADM...

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1 Financial Management ADM 2350 Professor: Dr. William F. Rentz
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2 ADM 2350 Chapter 7 This session develops the risk-return relationship for individual projects (investments) and a portfolio of projects
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3 Risk and Return Risk refers to the potential variability of returns from a project or portfolio of projects Returns are cash flows Risk-free returns are known with certainty Government bonds: certain to get gorvernment returns
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4 Expected Return A weighted average of the individual possible returns The symbol for expected return, r is called r hat.” r = Sum (all possible returns × their probability) ^ ^
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5 Let’s Analyze Risk Standard Deviation σ is an absolute measure of risk Z score measures the number of standard deviations a particular rate of return r is from the expected value of r Coefficient of variation v is a relative measure of risk Risk is an increasing function of time ^
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6 Calculating the Z Score Z score = What’s the probability of a loss on an investment with an expected return of 20 percent and a standard deviation of 17 percent? (0% – 20%)/17% = –1.18 rounded From table V = 0.1190 or 11.9 percent probability of a loss Target score – Expected value Standard deviation
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7 Coefficient of Variation The coefficient of variation v is an appropriate measure of total risk when comparing two investment projects of different size V = σ / r ^
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8 Risk-Return Relationship Required return = Risk-free return + Risk premium Real rate of return Risk-free rate Expected inflation premium
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9 Expected Inflation Premium Compensates investors for the loss of purchasing power due to inflation
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10 Risk Premium Maturity risk premium Default risk premium Seniority risk premium
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11 Risk Premium Marketability risk premium Business risk Financial risk
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12 Term Structure of Interest Rates Expectations theory Maturity premium theory Market segmentation theory
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Chapter 07 Financial Management - Financial Management ADM...

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