The document is a chapter from a corporate finance textbook that discusses risk, return, and the opportunity cost of capital. It covers topics such as rates of return, measuring risk through variance and standard deviation, diversification and its effects on risk, and historical data on market volatility and country risk premiums. The chapter aims to define key terms and concepts regarding risk and return and provide students with tools to analyze and think about risk in financial markets.

1. Chapter 10
Fundamentals of
Corporate
Finance
Fifth Edition
Slides by
Matthew Will
McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
Introduction to Risk, Return,
and the Opportunity Cost of
Capital

2. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
McGraw-Hill/Irwin
10- 2
Topics Covered
Rates of Return: A Review
A Century of Capital Market History
Measuring Risk
Risk & Diversification
Thinking About Risk

3. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
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10- 3
Rates of Return
20.2%
or
.202
=
31.12
.82
5.47
=
Return
Percentage

Percentage Return = Capital Gain + Dividend
Initial Share Price

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10- 4
Rates of Return
Dividend Yield = Dividend
Initial Share Price
Capital Gain Yield = Capital Gain
Initial Share Price

5. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
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10- 5
Rates of Return
%
2.6
or
026
.
31.12
0.82
=
Yield
Dividend

%
17.6
or
176
.
31.12
5.47
=
Yield
Gain
Capital


6. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
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10- 6
Rates of Return
Nominal vs. Real
1+ real ror = 1 + nominal ror
1 + inflation rate
%
4
.
16
ror
real
164
.
1
=
ror
real
+
1 .033
+
1
.202
+
1



7. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
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10- 7
Market Indexes
Dow Jones Industrial Average (The Dow)
Value of a portfolio holding one share in each of 30 large
industrial firms.
Standard & Poor’s Composite Index (The S&P 500)
Value of a portfolio holding shares in 500 firms. Holdings are
proportional to the number of shares in the issues.

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10- 8
The Value of an Investment of $1 in 1900
Source: Ibbotson Associates
1
10
100
1000
10000
100000
1
9
0
0
1
9
1
0
1
9
2
0
1
9
3
0
1
9
4
0
1
9
5
0
1
9
6
0
1
9
7
0
1
9
8
0
1
9
9
0
2
0
0
0
Common Stocks
Long T-Bonds
T-Bills
Index
Year End
$17,545
$160
$61
2004

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10- 9
Rates of Return
-0.6
-0.4
-0.2
0
0.2
0.4
0.6
Return
(%)
1
9
0
0
1
9
1
0
1
9
2
0
1
9
3
0
1
9
4
0
1
9
5
0
1
9
6
0
1
9
7
0
1
9
8
0
1
9
9
0
2
0
0
0
Year
Common Stocks (1900-2004)
2004

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10- 10
Expected Return
7.6
+
2.5
=
10.1%
(2005)
7.6
+
14
=
21.6%
(1981)
premium
risk
normal
+
bills
Treasury
on
rate
interest
=
return
market
Expected

11. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
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10- 11
Measuring Risk
Variance - Average value of squared deviations from
mean. A measure of volatility.
Standard Deviation - Average value of squared
deviations from mean. A measure of volatility.

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10- 12
Measuring Risk
Coin Toss Game-calculating variance and standard deviation
(1) (2) (3)
Percent Rate of Return Deviation from Mean Squared Deviation
+ 40 + 30 900
+ 10 0 0
+ 10 0 0
- 20 - 30 900
Variance = average of squared deviations = 1800 / 4 = 450
Standard deviation = square of root variance = 450 = 21.2%

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Risk and Diversification
Diversification - Strategy designed to reduce risk
by spreading the portfolio across many
investments.
Unique Risk - Risk factors affecting only that firm.
Also called “diversifiable risk.”
Market Risk - Economy-wide sources of risk that
affect the overall stock market. Also called
“systematic risk.”

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Risk and Diversification
Deviation from Squared
Year Rate of Return Average Return Deviation
1999 23.7 19.52 381.03
2000 (10.9) (15.08) 227.41
2001 (11.0) (15.18) 230.43
2002 (20.9) (25.08) 629.01
2003 31.6 27.42 751.86
2004 12.6 8.42 70.90
Total 25.1 2,290.63
Average rate of return = 25.1/6=4.18%
Variance = average of squared deviations = 2290.63/6=381.77
Standard deviation = squared root of variance = 19.54%

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10- 15
Risk and Diversification
Portfolio rate
of return
=
fraction of portfolio
in first asset
x
rate of return
on first asset
+
fraction of portfolio
in second asset
x
rate of return
on second asset
(
(
(
(
)
)
)
)

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10- 16
Stock Market Volatility 1926-2004
0
10
20
30
40
50
60
1
9
2
6
1
9
3
5
1
9
4
0
1
9
4
5
1
9
5
0
1
9
5
5
1
9
6
0
1
9
6
5
1
9
7
0
1
9
7
5
1
9
8
0
1
9
8
5
1
9
9
0
1
9
9
5
2
0
0
0
Std
Dev
2004

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Country Risk Premia (%)
0
2
4
6
8
10
12
Italy
Japan
France
Germany (ex 1922/3)
Australia
South Africa
Sweden
USA
Average
UK
Ireland
Canada
Spain
Switzerland
Belgium
Denmark
Norway

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Histogram of Returns

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Risk and Diversification
0
5 10 15
Number of Securities
Portfolio
standard
deviation

20. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
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10- 20
0
5 10 15
Number of Securities
Portfolio
standard
deviation
Market risk
Unique
risk
Risk and Diversification

21. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
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10- 21
Thinking About Risk
Message 1
Some Risks Look Big and Dangerous but
Really Are Diversifiable
Message 2
Market Risks Are Macro Risks