Lect 08 fin221

Lect 08 fin221 - Autumn 2011 Managerial Finance Lecture 8...

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Autumn 2011 1 Managerial Finance Lecture 8 Risk and the Cost of Capital
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Autumn 2011 2 Class 7: Summary 1 Discounted cash flow analysis : mechanics 1. Discounted cash flow analysis Free cash flows Terminal values and Discount rates 2. Discounted cash flow analysis : decision-making Understanding the key assumptions behind valuations Understanding the Relate firm and industry prospects and knowledge to DCF 3. Comparables (or multiple)-based valuation Easy valuation approach: pervasive Approximates value if firms are identical: typically they are not! Yet it contains market-based information: market value of “similar” assets Use it to understand differences in value: i.e. ask questions Do not use average multiples to make investment / sale recommendations 2
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Autumn 2011 3 The Objective: Fund Managers Today and in the next two sessions we will analyze Today and in the next two sessions, we will analyze stocks and bonds from the perspective of fund managers . Today’s objectives: 1. Learn how to measure risk 2. Understand what risks affect the discount rate (not all) 3. Understand how investors describe their portfolios Next class: identify how to form efficient portfolios 3
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Autumn 2011 4 Measuring Returns Recall the definition of the total return Recall the definition of the : Stock returns are highly variable over time: 10 1 1 00 PP Div R  Ford Motor Co. Year Stock Price Divs Paid Div Yield Cap Gain Total Return S&P 500 Total Ret 2000 18.960 2001 12.210 1.050 5.5% 35.6% 30.1% 11.8% 2002 7.710 0.400 3.3% 36.9% 33.6% 21.6% 2003 15.600 0.400 5.2% 102.3% 107.5% 28.7% 2004 13.210 0.400 2.6% 15.3% 12.8% 10.9% 2005 7.070 0.400 3.0% 46.5% 43.5% 4.9% 2006 7.260 0.250 3.5% 2.7% 6.2% 15.8% 4 What will be Ford’s return in the coming year ? The S&P 500’s? 2007 6.730 0.000 0.0% 7.3% 7.3% 5.5% 2008 2.290 0.000 0.0% 66.0% 66.0% 37.0% 2009 10.000 0.000 0.0% 336.7% 26.5% 2010 16.790 0.000 0.0% 67.9% 67.9% 15.1%
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Autumn 2011 5 Probability distribution When projects are risky there are different returns that a When projects are risky, there are different returns that a given project may earn: Each possible return has some likelihood of occurring (ex. beliefs) This information is summarized with a probability distribution , that assigns a probability, P R , that each possible return , R , will occur. Example: The stock of GE has the following probability distribution Probability Return 0.20 30.00 5 0.60 10.00
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Autumn 2011 6 Expected Return Given the probability distribution of returns we can Given the probability distribution of returns, we can calculate the expected return of an investment The expected or mean return is calculated as a weighted average of the possible returns: Where the weights correspond to the probabilities that each return is obtained. Example: What is GE’s expected return next year?  % 10 %) 10 ( * 2 . 0 % 10 * 6 . 0 % 30 * 2 . 0 GE R E 6 E[ R] refers to the expected return, often shown as R
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Autumn 2011 7 Measures of risk Another important characteristic of an investment is how Another important characteristic of an investment is how spread out ” or risky the probability distribution of returns is.
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This note was uploaded on 01/08/2012 for the course MS&E 245G taught by Professor Perez-gonzalas during the Fall '11 term at Stanford.

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Lect 08 fin221 - Autumn 2011 Managerial Finance Lecture 8...

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