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Lecture Fundamentals of financial management (13/e) - Chapter 5: Risk and return

We are now able to apply these concepts to determining the value of different securities. In particular, we are concerned with the valuation of the firm’s long-term securities – bonds, preferred stock, and common stock (though the principles discussed apply to other securities as well). | Chapter 5 Risk and Return © 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e Created by: Gregory A. Kuhlemeyer, Ph.D. Carroll College, Waukesha, WI Risk and Return Defining Risk and Return Using Probability Distributions to Measure Risk Attitudes Toward Risk Risk and Return in a Portfolio Context Diversification The Capital Asset Pricing Model (CAPM) Defining Return Income received on an investment plus any change in market price, usually expressed as a percent of the beginning market price of the investment. Dt + (Pt - Pt-1 ) Pt-1 R = Return Example The stock price for Stock A was $10 per share 1 year ago. The stock is currently trading at $9.50 per share, and shareholders just received a $1 dividend. What return was earned over the past year? Return Example The stock price for Stock A was $10 per share 1 year ago. The stock is currently trading at $9.50 per share, and shareholders just received a $1 dividend. What return was earned over the past year? $1.00 + ($9.50 - $10.00 ) $10.00 R = = 5% Defining Risk What rate of return do you expect on your investment (savings) this year? What rate will you actually earn? Does it matter if it is a bank CD or a share of stock? The variability of returns from those that are expected. Determining Expected Return (Discrete Dist.) R = S ( Ri )( Pi ) R is the expected return for the asset, Ri is the return for the ith possibility, Pi is the probability of that return occurring, n is the total number of possibilities. n i=1 How to Determine the Expected Return and Standard Deviation Stock BW Ri Pi (Ri)(Pi) -.15 .10 -.015 -.03 .20 -.006 .09 .40 .036 .21 .20 .042 .33 .10 .033 Sum 1.00 .090 The expected return, R, for Stock BW is .09 or 9% Determining Standard Deviation (Risk Measure) s = S ( Ri - R )2( Pi ) Standard Deviation, s, is a statistical measure of the variability of a distribution around its mean. It is the square root of variance. Note, this is for a discrete distribution. n i=1 How to Determine the . | Chapter 5 Risk and Return © 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e Created by: Gregory A. Kuhlemeyer, Ph.D. Carroll College, Waukesha, WI Risk and Return Defining Risk and Return Using Probability Distributions to Measure Risk Attitudes Toward Risk Risk and Return in a Portfolio Context Diversification The Capital Asset Pricing Model (CAPM) Defining Return Income received on an investment plus any change in market price, usually expressed as a percent of the beginning market price of the investment. Dt + (Pt - Pt-1 ) Pt-1 R = Return Example The stock price for Stock A was $10 per share 1 year ago. The stock is currently trading at $9.50 per share, and shareholders just received a $1 dividend. What return was earned over the past year? Return Example The stock price for Stock A was $10 per share 1 year ago. The stock is currently trading at $9.50 per share, and shareholders just received a $1 dividend. What return was earned over the past year? $1.00 + .