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Unformatted text preview: ECON*2560- THEORY OF FINANCE CHAPTER 10: INTRODUCTION TO RISK, RETURN, AND THE OPPORTUNITY COST OF CAPITAL- In previous chapter we measured risk as the cost of capital Cost of capital: the rate of return that is expected to be earned if the funds for the project are invested in equally risky securities o Thus, one way to estimate a projects cost of capital is to find traded securities that have the same risk as the project and then estimate the expected rate of return on these securities - from this we can determine the rates of return from pas securities and examine the extra return investors received from investing in these risky securities o furthermore we can measure risk by calculating standard deviation and examining the past history to access risk- we can also diversify portfolios to lessen risk RATES OF RETURN: A REVIEW - when investors buy stock or bond, return comes in two forms ; 1. A dividend or interest payment 2. A capital gain or capital loss - Percentage return can be expressed mathematically such that, Percentage return: capital gain + dividend Initial share price o The percentage return can also be expressed as the sum of the dividend yield and percentage capital gain This just puts both capital gain and dividend into a percentage , and therefore, does not need to be divided by the initial share price( as the percentage return does ) Percentage return = dividend yield + percentage capital gain Dividend yield: the dividend expressed as a percentage of the stock price at the beginning of the year Dividend yield= dividend . Initial share price- Similarly, the percentage capital gain can be calculated such that , Percentage capital gain= capital gain . Initial share price - In addition, the distinction between nominal rate of return and the real rate of return will affect the how much money we earn o The nominal return measure how much more money you will have at the end of the year if you invest today o While the real rate of return tells you how much more you will be able to but with your money at the end of the year - To convert from a nominal to real rate of return, we use the following formula 1+real rate of return= 1+nominal rate of return 1+ inflation rate Through the analysis of this formula we can see that, IF real rate of return is less than the nominal rate of return when the inflation rate is positive 10.2 EIGHTY-TWO YEARS OF CAPITAL MARKET HISTORY- Investing in stocks is tricky, you can never really be certain of the return that you will earn You can however look at the history of security returns to get some idea of the return investors might reasonably expect from investments MARKET INDEXES - Investors can choose from enormous selection of securities ; common shares, preferred shares, income trust units, and convertible debentures of more than 1,600 large, established companies are listed for trading on the Toronto stock exchange (TSX)- Canadian investors free to cross- border shop in U.S and overseas markets Canadian investors free to cross- border shop in U....
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This note was uploaded on 02/13/2012 for the course ECON 2560 taught by Professor Bower during the Spring '11 term at University of Guelph.

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