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Chapter 1 An Overview of Managerial Finance


Title: Chapter 1 An Overview of Managerial Finance Author: Susan Cook Last modified by: JEFFREY P. MARANAN Created Date: 1/24/2004 6:24:47 PM Document presentation format – PowerPoint PPT presentation

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Title: Chapter 1 An Overview of Managerial Finance


Chapter 4 Risk and Rates of Return
Defining and Measuring Risk
  • Risk is the chance that an unexpected outcome
    will occur
  • A probability distribution is a listing of all
    possible outcomes with a probability assigned to
  • must sum to 1.0 (100).

Expected Rate of Return
  • Rate of return expected to be realized from an
    investment during its life
  • Mean value of the probability distribution of
    possible returns
  • Weighted average of the outcomes, where the
    weights are the probabilities

Expected Rate of Return
State of the economy Prob. Martin Product RETURNS Martin Product RETURNS US Electric RETURNS US Electric RETURNS
(1) (2) (3) (4) (2 x 3) (5) (6) (2 x 5)
Boom 0.2 110 20
Normal 0.5 22 16
Recession 0.3 -60 10
Expected Rate of Return
Continuous versus Discrete Probability
  • Continuous Probability Distribution number of
    possible outcomes is unlimited, or infinite.

Measuring Risk The Standard Deviation Martin
K E(K) K E(K) K E(K)2 Pr. K E(K)2 x Pr
(1) (2) (3) (1 2) (4) (5) (6) (4 x 5)
110 0.2
22 0.5
-60 0.3

Measuring Risk The Standard Deviation
Measuring Risk Coefficient of Variation
  • Standardized measure of risk per unit of return
  • Calculated as the standard deviation divided by
    the expected return
  • Useful where investments differ in risk and
    expected returns

Risk Aversion and Required Returns
  • Risk Premium (RP)
  • The portion of the expected return that can be
    attributed to an investments risk beyond a
    riskless investment
  • The difference between the expected rate of
    return on a given risky asset and that on a less
    risky asset

Portfolio Risk and the Capital Asset Pricing Model
  • CAPM
  • A model based on the proposition that any stocks
    required rate of return is equal to the risk-free
    rate of return plus a risk premium, where risk is
    based on diversification.
  • Portfolio
  • A collection of investment securities

Portfolio Risk and Return
  • The goal of finance manager is to create
  • AN EFFICIENT PORTFOLIO Maximizes return
  • for a given level of risk or minimizes risk for a
  • given level of return.

Portfolio Returns
  • Expected return on a portfolio,
  • The weighted average expected return on the
    stocks held in the portfolio

Portfolio Returns
  • Realized rate of return, k
  • The return that is actually earned
  • Actual return usually different from expected

Portfolio Risk
  • Correlation Coefficient, r
  • Measures the degree of relationship between two
  • Perfectly correlated stocks have rates of return
    that move in the same direction.
  • Negatively correlated stocks have rates of return
    that move in opposite directions.

Portfolio size and risk
  • Inc size of a portfolio ? risk dec
  • Risk dec to a certain point .. (Co. risk 0)
  • If we take all sec in the stock mkt as one
    portfolio (max size) ? still some risk exist
    (Market Risk) relevant risk the contribution
    of a secs risk to a portfolio.

Portfolio Risk
  • Risk Reduction
  • Combining stocks that are not perfectly
    correlated will reduce the portfolio risk through
  • The riskiness of a portfolio is reduced as the
    number of stocks in the portfolio increases.
  • The smaller the positive correlation, the lower
    the risk.

Firm-Specific Risk versus Market Risk
  • Firm-Specific Risk
  • That part of a securitys risk associated with
    random outcomes generated by events, or
    behaviors, specific to the firm.
  • Firm-specific risk can be eliminated through
    proper diversification.

Firm-Specific Risk versus Market Risk
  • Market Risk
  • That part of a securitys risk that cannot be
    eliminated through diversification because it is
    associated with economic, or market factors that
    systematically affect all firms.

Firm-Specific Risk versus Market Risk
  • Relevant Risk
  • The risk of a security that cannot be diversified
    away, or its market risk.
  • This reflects a securitys contribution to a
    portfolios total risk.

  • .. of thinking how risky a security is if helf in
    isolation you need to measure its market risk
    measure how sensitive it is to market this
    sensitivity is called BETA

The Concept of Beta
  • Beta Coefficient, b
  • A measure of the extent to which the returns on a
    given stock move with the stock market.
  • b 0.5 Stock is only half as volatile, or
    risky, as the average stock.
  • b 1.0 Stock has the same risk as the average
  • b 2.0 Stock is twice as risky as the average

Steps in deriving Beta
  • Plot mkt ret (X) and asset ret (Y) at various
    point in time.
  • Regression the slope beta
  • The higher the beta the higher the risk
  • Beta for the market 1, all other betas are
    viewed in relation to this value.
  • Beta may be ve or v, ve is the norm
  • Majority of betas fall between .5 and 2.

Portfolio Beta Coefficients
  • The beta of any set of securities is the weighted
    average of the individual securities betas
  • IF mkt ret inc by 10, a port with a beta of .75
    will experience a 7.5 inc in its return (.75 x

The Relationship Between Risk and Rates of Return
Market Risk Premium
  • RPM is the additional return over the risk-free
    rate needed to compensate investors for assuming
    an average amount of risk.
  • Assuming
  • Treasury bonds yield 6,
  • Average stock required return 14,
  • Then the market risk premium is 8 percent
  • RPM kM - kRF 14 - 6 8.

The Required Rate of Return for a Stock
  • Security Market Line (SML)
  • The line that shows the relationship between risk
    as measured by beta and the required rate of
    return for individual securities.

Security Market Line - CAPM
The Impact of Inflation
  • kRF is the price of money to a riskless borrower.
  • The nominal rate consists of
  • a real (inflation-free) rate of return, and
  • an inflation premium (IP).
  • An increase in expected inflation would increase
    the risk-free rate.

Changes in Risk Aversion
  • The slope of the SML reflects the extent to which
    investors are averse to risk.
  • An increase in risk aversion increases the risk
    premium and increases the slope.

Changes in a Stocks Beta Coefficient
  • The Beta risk of a stock is affected by
  • composition of its assets,
  • use of debt financing,
  • increased competition, and
  • expiration of patents.
  • Any change in the required return (from change in
    beta or in expected inflation) affects the stock

Stock Market Equilibrium
  • The condition under which the expected return on
    a security is just equal to its required return
  • Actual market price equals its intrinsic value as
    estimated by the marginal investor, leading to
    price stability

Changes in Equilibrium Stock Prices
  • Stock prices are not constant due to changes in
  • Risk-free rate, kRF,
  • Market risk premium, kM kRF,
  • Stock Xs beta coefficient, bx,
  • Stock Xs expected growth rate, gX, and
  • Changes in expected dividends, D0.