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BFIN620_PPT_CH10_sp09-5

# BFIN620_PPT_CH10_sp09-5 - 10 1 Business Finance 620 Risk...

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10- 1 Risk, Return and the Risk, Return and the Opportunity Cost of Capital Opportunity Cost of Capital Chapter 10 Brealey-Myers-Marcus 5 th Edition Business Finance 620

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10- 2 Topics Covered Measuring returns on investments Dollar return on investment Total rate of return (or % total return) Holding period rate of return Rates of return and inflation Capital market history Measuring investment risk Total risk Risk specific to the firm Market risk Risk and diversification
10- 3 Dollar Return on Investment Return on investment has two components: Income Price change (capital gain or loss) Income would include interest payments on a bond or cash dividends on common stock. Adding an investment’s dollar income to the dollar change in price yields the total dollar return : Total dollar return = (Investment income) + (Price change)

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10- 4 Total Rate of Return The total rate of return (R 1 ) on a share of common stock can be written in the form: where: P 0 is the purchase (initial) price P 1 is the sale (ending) price DIV is the dividend income paid from the date of purchase to the date of sale - + = 0 0 1 1 P ) P (P DIV 100 ) (R Return of Rate Total
10- 5 Components of Total Return Total return can be subdivided into 2 parts: An income return (“dividend yield”) A capital gains return (“capital gains yield”) which can be positive or negative. Mathematically, total rate of return becomes: Yield Gains Capital Yield Dividend R P ) P (P 100 P DIV 100 R P ) P (P DIV 100 R 1 0 0 1 0 1 0 0 1 1 + = - + = - + =

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10- 6 Total Rate of Return Application If you buy a stock today for \$58 a share, and sell it fifteen months from today for \$74, after receiving total cash dividends of \$3.35, what is the stock’s total return? Total returns calculated in this manner also are called holding-period returns . The holding (ownership) period is 15 months. During this period, your total return was 33.4%. 33.4% 58 ) 58 (74 3.35 100 R Months 15 = - + =
10- 7 Total Rate of Return Application The 33.4% total return can be divided into its two component parts. The dividend yield is 5.8% . The capital gains yield is 27.6% . 5.8% 58 3.35 100 Yield Dividend = × = 27.6% 58 58) (74 100 Yield Gains Capital = - × =

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10- 8 Rates of Return and Inflation Nominal total rates of return (computed from nominal dollars) can be converted into real total rates of return . Real total rates of return remove the effect of inflation, isolating the actual (real) change in purchasing power. With a 2.5% rate of inflation over 15 months, a nominal total return of 33.4% represents a real total rate of return of 30.1% : 30.1% . 1.334 Rate Inflation 1 Rate Nominal 1 rate Real = - = - + + = 1 025 1 1
10- 9 The Value 100 Years Later of an Investment of \$1 in 1900 Source: Ibbotson Associates 0.1 10 1000 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 Common Stocks Long T-Bonds T-Bills Index Year End \$14,953 \$124 \$59

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10- 10 Rates of Return on Common Stock 1900-2004 -0.6 -0.4 -0.2 0 0.2 0.4 0.6 Return (% 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 Year High average returns came at the price of wide fluctuations.
10- 11 Returns on Different Asset Classes Not all asset classes experienced the same volatility of returns.

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BFIN620_PPT_CH10_sp09-5 - 10 1 Business Finance 620 Risk...

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