Chapter8PrinciplesofCorporateFinanceNinthEditionIntroductiontoRisk,Return,andTheOpportunityCostofCapitalSlidesbyMatthewWillCopyright?2021byTheMcGraw-HillCompanies,Inc.AllrightsreservedMcGrawHill/IrwinTopicsCoveredOveraCenturyofCapitalMarketHistoryMeasuringPortfolioRiskCalculatingPortfolioRiskHowIndividualSecuritiesAffectPortfolioRiskDiversification&ValueAdditivityTheValueofanInvestmentof$1in1900TheValueofanInvestmentof$1in1900RealReturnsAverageMarketRiskPremia(bycountry)Riskpremium,%CountryDividendYield(1900-2006)RatesofReturn1900-2006Source:IbbotsonAssociatesYearPercentageReturnStockMarketIndexReturnsMeasuringRiskReturn%#ofYearsHistogramofAnnualStockMarketReturns(1900-2006)EquityMarketRisk(bycountry)StandardDeviationofAnnualReturns,%AverageRisk(1900-2006)DowJonesRiskAnnualizedStandardDeviationoftheDJIAoverthepreceding52weeks(1900–2006)MeasuringRiskVariance-Averagevalueofsquareddeviationsfrommean.Ameasureofvolatility.StandardDeviation-Averagevalueofsquareddeviationsfrommean.Ameasureofvolatility.MeasuringRiskCoinTossGame-calculatingvarianceandstandarddeviationMeasuringRiskDiversification-Strategydesignedtoreduceriskbyspreadingtheportfolioacrossmanyinvestments.UniqueRisk-Riskfactorsaffectingonlythatfirm.Alsocalled“diversifiablerisk.〞MarketRisk-Economy-widesourcesofriskthataffecttheoverallstockmarket.Alsocalled“systematicrisk.〞MeasuringRiskMeasuringRiskMeasuringRiskPortfolioRiskThevarianceofatwostockportfolioisthesumofthesefourboxesPortfolioRiskExample

Supposeyouinvest60%ofyourportfolioinWal-Martand40%inIBM.TheexpecteddollarreturnonyourWal-Martstockis10%andonIBMis15%.Theexpectedreturnonyourportfoliois:PortfolioRiskExample

Supposeyouinvest60%ofyourportfolioinWal-Martand40%inIBM.TheexpecteddollarreturnonyourWal-Martstockis10%andonIBMis15%.Thestandarddeviationoftheirannualizeddailyreturnsare19.8%and29.7%,respectively.Assumeacorrelationcoefficientof1.0andcalculatetheportfoliovariance.PortfolioRiskExample

Supposeyouinvest60%ofyourportfolioinWal-Martand40%inIBM.TheexpecteddollarreturnonyourWal-Martstockis10%andonIBMis15%.Thestandarddeviationoftheirannualizeddailyreturnsare19.8%and29.7%,respectively.Assumeacorrelationcoefficientof1.0andcalculatetheportfoliovariance.PortfolioRiskExample

Supposeyouinvest60%ofyourportfolioinExxonMobiland40%inCocaCola.TheexpecteddollarreturnonyourExxonMobilstockis10%andonCocaColais15%.Theexpectedreturnonyourportfoliois:PortfolioRiskExample

Supposeyouinvest60%ofyourportfolioinExxonMobiland40%inCocaCola.TheexpecteddollarreturnonyourExxonMobilstockis10%andonCocaColais15%.Thestandarddeviationoftheirannualizeddailyreturnsare18.2%and27.3%,respectively.Assumeacorrelationcoefficientof1.0andcalculatetheportfoliovariance.PortfolioRiskExample

Supposeyouinvest60%ofyourportfolioinExxonMobiland40%inCocaCola.TheexpecteddollarreturnonyourExxonMobilstockis10%andonCocaColais15%.Thestandarddeviationoftheirannualizeddailyreturnsare18.2%and27.3%,respectively.Assumeacorrelationcoefficientof1.0andcalculatetheportfoliovariance.PortfolioRiskPortfolioRiskExampleCorrelationCoefficient=.4Stocks s %ofPortfolio AvgReturnABCCorp 28 60% 15%BigCorp 42 40% 21%StandardDeviation=weightedavg=33.6StandardDeviation=Portfolio=28.1

RealStandardDeviation: =(282)(.62)+(422)(.42)+2(.4)(.6)(28)(42)(.4) =28.1CORRECTReturn:r=(15%)(.60)+(21%)(.4)=17.4%PortfolioRiskExampleCorrelationCoefficient=.4Stocks s %ofPortfolio AvgReturnABCCorp 28 60% 15%BigCorp 42 40% 21%StandardDeviation=weightedavg=33.6StandardDeviation=Portfolio=28.1

Return=weightedavg=Portfolio=17.4%Let’sAddstockNewCorptotheportfolioPortfolioRiskExampleCorrelationCoefficient=.3Stocks s %ofPortfolio AvgReturnPortfolio 28.1 50% 17.4%NewCorp 30 50% 19%NEWStandardDeviation=weightedavg=31.80

NEWStandardDeviation=Portfolio=23.43

NEWReturn=weightedavg=Portfolio=18.20%NOTE:Higherreturn&LowerriskHowdidwedothat? DIVERSIFICATIONPortfolioRiskTheshadedboxescontainvarianceterms;theremaindercontaincovarianceterms.123456N123456NSTOCKSTOCKTocalculateportfoliovarianceadduptheboxesBetaandUniqueRiskbetaExpectedreturnExpectedmarketreturn10%10%-+10%+10%stockCopyright1996byTheMcGraw-HillCompanies,Inc-10%1.Totalrisk=diversifiablerisk+marketrisk2.Marketriskismeasuredbybeta,thesensitivitytomarketchangesBetaandUniqueRiskMarketPortfolio-Portfolioofallassetsintheeconomy.Inpracticeabroadstockmarketindex,suchastheS&PComposite,isusedtorepresentthemarket.