4-1 Business Finance (MGT 232) Lecture 13

4-2 Risk and Return

4-3 Dividend Growth Models Constant Growth Model Zero Growth Model Variable Growth Model Overview of the Last Lecture

4-4 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 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)

4-5 Risk and Return The basic premise of investment is risk and return Investment – Money spent with the intention of getting more in future Return = Amt Received – Amt Invested Rate of return = Amt Received – Amt Invested Amt Invested The basic premise of investment is risk and return Investment – Money spent with the intention of getting more in future Return = Amt Received – Amt Invested Rate of return = Amt Received – Amt Invested Amt Invested

4-6 Defining Return Income received change in market price beginning market price Income received on an investment plus any change in market price, usually expressed as a percent of the beginning market price of the investment. D t P t - P t-1 D t + (P t - P t-1 ) P t-1 R =

4-7 Return Example Rs.10 Rs.9.50 Rs.1 dividend The stock price for Stock A was Rs.10 per share 1 year ago. The stock is currently trading at Rs.9.50 per share, and shareholders just received a Rs.1 dividend. What return was earned over the past year?

4-8 Risk and Return Investment Standalone Investment Portfolio Investment -Standalone Return -Standalone Risk -Portfolio Return -Portfolio Risk

4-9 Standalone Expected Return Expected rate of return on an asset is the weighted average of possible outcomes on an investment, with weights being probabilities r = r 1 P 1 + r 2 P 2 +…..+r n P n Expected rate of return on an asset is the weighted average of possible outcomes on an investment, with weights being probabilities r = r 1 P 1 + r 2 P 2 +…..+r n P n ^

4-10 Determining Expected Return r =  ( r i )( P i ) r is the expected return for the asset, r i is the return for the i th possibility, P i is the probability of that return occurring, n is the total number of possibilities. r =  ( r i )( P i ) r is the expected return for the asset, r i is the return for the i th possibility, P i is the probability of that return occurring, n is the total number of possibilities. n i=1 ^ ^

4-11 How to Determine the Expected Return and Standard Deviation Stock BW r i P i (r i )(P i ) Sum Stock BW r i P i (r i )(P i ) Sum The expected return, R, for Stock BW is.09 or 9%

4-12 Expected Return Example Stock A Stock B Prob r a r b P i 20% 100% % 15% % (70%) 0.3 Sum 1.00 Stock A Stock B Prob r a r b P i 20% 100% % 15% % (70%) 0.3 Sum 1.00

4-13 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? 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.

4-14 Standalone Risk The Probability that the actual return would be different from expected return   =  ( r i - r ) 2 ( P i ) Standard Deviation  Standard Deviation, , is a statistical measure of the variability of a distribution around its mean. It is the square root of variance. The Probability that the actual return would be different from expected return   =  ( r i - r ) 2 ( P i ) Standard Deviation  Standard Deviation, , is a statistical measure of the variability of a distribution around its mean. It is the square root of variance. n i=1 ^

4-15 How to Determine the Expected Return and Standard Deviation Stock BW r i P i (r i )(P i ) (r i - r ) 2 (P i ) Sum Stock BW r i P i (r i )(P i ) (r i - r ) 2 (P i ) Sum ^

4-16 Determining Standard Deviation

4-17 Standard Deviation Example Stock A Stock B Prob r a r b P i 20% 100% % 15% % (70%) 0.3 Sum 1.00 Stock A Stock B Prob r a r b P i 20% 100% % 15% % (70%) 0.3 Sum 1.00

4-18 Determining Standard Deviation

4-19 Coefficient of Variation standard deviation mean The ratio of the standard deviation of a distribution to the mean of that distribution. RELATIVE It is a measure of RELATIVE risk.  r CV =  / r CV of BW =.1315 /.09 = 1.46 standard deviation mean The ratio of the standard deviation of a distribution to the mean of that distribution. RELATIVE It is a measure of RELATIVE risk.  r CV =  / r CV of BW =.1315 /.09 = 1.46

4-20 Coefficient of Variation The Chance that the actual return would vary: % or 15-65% 80% To - 50% CV shows risk per unit of return, the lower the CV the better it is The Chance that the actual return would vary: % or 15-65% 80% To - 50% CV shows risk per unit of return, the lower the CV the better it is

4-21 Coefficient of Variation A B R 15% 30%  C.V a C.V b A B R 15% 30%  C.V a C.V b

4-22 Summary Risk and Return Stand Alone Expected return Stand alone risk Coefficient of variance