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Ch06 Show

# Ch06 Show - CHAPTER 6 Risk Return and the Capital Asset...

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1 CHAPTER 6 Risk, Return, and the  Capital Asset Pricing  Model

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2 Topics in Chapter n Basic return concepts n Basic risk concepts n Stand-alone risk n Portfolio (market) risk n Risk and return: CAPM/SML
Value =                         +                         +     + FCF1 FCF2 FCF (1 + WACC)1 (1 + WACC) (1 + WACC)2 Free cash  flow (FCF) Market interest rates Firm’s business risk Market risk aversion Firm’s debt/equity mix Cost of debt Cost of equity Weighted  average cost of capital (WACC) Net operating profit after  taxes Required  investments in operating capital = Determinants of Intrinsic Value: The Cost of Equity ...

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4 What are investment returns? n Investment returns measure the  financial results of an investment. n Returns may be historical or prospective  (anticipated). n Returns can be expressed in: n Dollar terms. n Percentage terms.
5 An investment costs \$1,000 and is  sold after 1 year for \$1,100. Dollar return: Percentage return: \$ Received  -  \$ Invested     \$1,100      -   \$1,000       = \$100. \$ Return/\$ Invested       \$100/\$1,000        = 0.10 = 10%.

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6 What is investment risk? n Typically, investment returns are not  known with certainty. n Investment risk pertains to the  probability of earning a return less than  that expected. n The greater the chance of a return far  below the expected return, the greater  the risk.
7 Probability Distribution: Which  stock is riskier?  Why? -30 -15 0 15 30 45 60 Returns (% ) Stock A Stock B

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8 Consider the Following Investment Alternatives Econ. Prob. T-Bill Alta Repo Am F. MP Bust  0.10 8.0% -22.0%   28.0%   10.0% -13.0% Below avg.  0.20 8.0   -2.0   14.7 -10.0   1.0 Avg.  0.40 8.0   20.0     0.0   7.0   15.0 Above avg.  0.20  8.0   35.0 -10.0   45.0   29.0 Boom  0.10  8.0   50.0 -20.0   30.0   43.0  1.00
9 What is unique about the T-bill  return? n The T-bill will return 8% regardless of  the state of the economy. n Is the T-bill riskless?  Explain.

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10 Alta Inds. and Repo Men vs.  the Economy n Alta Inds. moves with the economy, so it  is positively correlated with the  economy.  This is the typical situation. n Repo Men moves counter to the  economy.  Such negative correlation is  unusual.
11 Calculate the expected rate of  return on each alternative. r = expected rate of return. rAlta = 0.10(-22%) + 0.20(-2%) + 0.40(20%) + 0.20(35%) + 0.10(50%) = 17.4%. ^ ^ n r = ^ i=1 riPi.

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12 Alta has the highest rate of  return. Does that make it best? ^ r Alta    17.4% Market 15.0 Am. Foam 13.8 T-bill   8.0 Repo Men   1.7
13 What is the standard deviation of returns for each alternative?

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Ch06 Show - CHAPTER 6 Risk Return and the Capital Asset...

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