Fundamentals of Corporate Finance/3e,ch10

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Fundamentals of Corporate Finance/3e,ch10

  1. 1. Copyright  2004 McGraw-Hill AustraliaPty Ltd10-1Chapter TenSome Lessons from CapitalMarket History
  2. 2. Copyright  2004 McGraw-Hill AustraliaPty Ltd10-210.1 Returns10.2 Inflation and Returns10.3 The Historical Record10.4 Average Returns: The First Lesson10.5 The Variability of Returns: The Second Lesson10.6 Capital Market Efficiency10.7 Summary and ConclusionsChapter Organisation
  3. 3. Copyright  2004 McGraw-Hill AustraliaPty Ltd10-3Chapter Objectives• Distinguish between dollar returns and percentage returns.• Examine the effect of inflation on returns.• Gain an appreciation of historical returns and their variabilityfor different assets.• Calculate average return and standard deviation.• Discuss market efficiency and its three forms.
  4. 4. Copyright  2004 McGraw-Hill AustraliaPty Ltd10-4Dollar Returns• The gain (or loss) from an investment.• Made up of two components:– income (e.g. dividends, interest payments)– capital gain (or loss).• Not necessary to sell investment to include capital gain orloss in return.
  5. 5. Copyright  2004 McGraw-Hill AustraliaPty Ltd10-5Dividends paid at Change in marketend of period value over periodPercentage return =Beginning market valueDividends paid at Market valueend of period at end of period1 + Percentage return =Beginning market value++Percentage Returns
  6. 6. Copyright  2004 McGraw-Hill AustraliaPty Ltd10-6Percentage Return ExamplePt = $37.00 Pt+1 = $40.33 Dt+1 = $1.85( )14%or0.14$37.00$37.00$40.33$1.85Return%=−+=Per dollar invested we get 5 cents in dividends and 9cents in capital gains—a total of 14 cents or a return of14 per cent.
  7. 7. Copyright  2004 McGraw-Hill AustraliaPty Ltd10-7InflowsOutflows$42.18$1.85$40.33TotalDividendsEndingmarket valuet = 1t– $37TimePercentage Returns
  8. 8. Copyright  2004 McGraw-Hill AustraliaPty Ltd10-8Inflation and Returns• Real return is the return after taking out the effects ofinflation.• Real return shows the percentage change in buying power.• Nominal return is the return before taking out the effects ofinflation.• The Fisher effect explores the relationship between realreturns (r), nominal returns (R) and inflation (h).( ) ( ) ( )hrR +×+=+ 111R ≈ r + h
  9. 9. Copyright  2004 McGraw-Hill AustraliaPty Ltd10-9Average Equivalent Returns& Risk Premiums 1978–2002
  10. 10. Copyright  2004 McGraw-Hill AustraliaPty Ltd10-10Average Returns: The First LessonRisky assets on average earn a risk premium (i.e. there is areward for bearing risk).
  11. 11. Copyright  2004 McGraw-Hill AustraliaPty Ltd10-11Frequency of Returns on OrdinaryShares 1978–2002
  12. 12. Copyright  2004 McGraw-Hill AustraliaPty Ltd10-12Variance• Measure of variability.• The mean of the squared deviations from the average return.( ) ( ) ( )[ ]22111Var RR....RRTR T −++−×−=
  13. 13. Copyright  2004 McGraw-Hill AustraliaPty Ltd10-13Example—VarianceABC Co. have experienced the following returns in the lastfive years:Calculate the average return and the standard deviation.Year Returns1998 -10%1999 5%2000 30%2001 18%2002 10%
  14. 14. Copyright  2004 McGraw-Hill AustraliaPty Ltd10-14Example—Variance
  15. 15. Copyright  2004 McGraw-Hill AustraliaPty Ltd10-15Example—Variance( )14.89%or0.14890.02218deviationStd0.02218150.08872Variance===−=
  16. 16. Copyright  2004 McGraw-Hill AustraliaPty Ltd10-16The Historical RecordConclusion: Historically, the riskier the asset, thegreater the return.
  17. 17. Copyright  2004 McGraw-Hill AustraliaPty Ltd10-17The Normal Distribution
  18. 18. Copyright  2004 McGraw-Hill AustraliaPty Ltd10-18Variability: The Second Lesson• The greater the risk, the greater the potential reward.• This lesson holds over the long term but may not be valid forthe short term.
  19. 19. Copyright  2004 McGraw-Hill AustraliaPty Ltd10-19Capital Market Efficiency• The efficient market hypothesis (EMH) asserts that the priceof a security accurately reflects all available information.• Implies that all investments have a zero NPV.• Implies also that all securities are fairly priced.• If this is true then investors cannot earn ‘abnormal’ or‘excess’ returns.
  20. 20. Copyright  2004 McGraw-Hill AustraliaPty Ltd10-20Price ($)Days relativeto announcement day–8 –6 –4 –2 0 +2 +4 +6 +7220180140100Overreaction andcorrectionDelayed reactionEfficient market reactionPrice Behaviour in Efficient andInefficient Markets
  21. 21. Copyright  2004 McGraw-Hill AustraliaPty Ltd10-21What Makes Markets Efficient?• There are many investors out there doing research:- As new information comes into the market, thisinformation is analysed and trades are madebased on this information.- Therefore, prices should reflect all availablepublic information.• If investors stop researching stocks, then themarket will not be efficient.
  22. 22. Copyright  2004 McGraw-Hill AustraliaPty Ltd10-22Common misconceptions about EMH• Efficient markets do not mean that you can’t makemoney.• They do mean that, on average, you will earn areturn that is appropriate for the risk undertakenand that there is not a bias in prices that can beexploited to earn excess returns.• Market efficiency will not protect you from makingthe wrong choices if you do not diversify—you stilldon’t want to put all your eggs in one basket
  23. 23. Copyright  2004 McGraw-Hill AustraliaPty Ltd10-23Price Behaviour in Efficient andInefficient Markets• Efficient market reaction: The price instantaneouslyadjusts to and fully reflects new information. Thereis no tendency for subsequent increases anddecreases.• Delayed reaction: The price partially adjusts to thenew information. Several days elapse before theprice completely reflects the new information.• Overreaction: The price over-adjusts to the newinformation. It ‘overshoots’ the new price andsubsequently corrects itself.
  24. 24. Copyright  2004 McGraw-Hill AustraliaPty Ltd10-24Forms of Market Efficiency• Weak form efficiency: Current prices reflect informationcontained in the past series of prices.• Semi-strong form efficiency: Current prices reflect all publiclyavailable information.• Strong form efficiency: Current prices reflect all information ofevery kind.

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