9-0 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Corporate Finance Ross  Westerfield  Jaffe Sixth Edition 9 Chapter Nine Capital Market Theory: An Overview Prepared by Gady Jacoby University of Manitoba and Sebouh Aintablian American University of Beirut

9-1 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Chapter Outline 9.1Returns 9.2Holding-Period Returns 9.3Return Statistics 9.4Average Stock Returns and Risk-Free Returns 9.5Risk Statistics 9.6Summary and Conclusions

9-2 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 9.1Returns Dollar Returns –the sum of the cash received and the change in value of the asset, in dollars. Time01 Initial investment Ending market value Dividends Percentage Returns – the sum of the cash received and the change in value of the asset divided by the original investment.

9-3 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Dollar Return = Dividend + Change in Market Value 9.1Returns

9-4 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 9.1Returns: Example Suppose you bought 100 shares of BCE one year ago today at $25. Over the last year, you received $20 in dividends (= 20 cents per share × 100 shares). At the end of the year, the stock sells for $30. How did you do? Quite well. You invested $25 × 100 = $2,500. At the end of the year, you have stock worth $3,000 and cash dividends of $20. Your dollar gain was $520 = $20 + ($3,000 – $2,500). Your percentage gain for the year is

9-5 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 9.1Returns: Example Dollar Returns –$520 gain Time01 -$2,500 $3,000$20 Percentage Returns

9-6 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 9.2Holding Period Returns The holding period return is the return that an investor would get when holding an investment over a period of n years, when the return during year i is given as r i :

9-7 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Holding Period Return: Example Suppose your investment provides the following returns over a four-year period:

9-8 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Holding Period Return: Example An investor who held this investment would have actually realized an annual return of 9.58%: So, our investor made 9.58% on his money for four years, realizing a holding period return of 44.21%

9-9 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Holding Period Return: Example Note that the geometric average is not the same thing as the arithmetic average:

9-10 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Holding Period Returns A famous set of studies dealing with the rates of returns on common stocks, bonds, and Treasury bills in the U.S. was conducted by Roger Ibbotson and Rex Sinquefield. James Hatch and Robert White examined Canadian returns. The text presents year-by-year historical rates of return starting in 1948 for the following five important types of financial instruments: –Large-Company Canadian Common Stocks –Large-Company U.S. Common Stocks –Small-Company Canadian Common Stocks –Long-Term Canadian Bonds –Canadian Treasury Bills

9-11 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited The Future Value of an Investment of $1 in 1948 $41.09 $21.48

9-12 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 9.3Return Statistics The history of capital market returns can be summarized by describing the –average return –the standard deviation of those returns –the frequency distribution of the returns.

9-13 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Average Standard Investment Annual Return Deviation Distribution Canadian common stocks 13.09%16.48% Long Bonds Treasury Bills Inflation Historical Returns, – 60%+ 60%0%

9-14 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 9.4 Average Stock Returns and Risk-Free Returns The Risk Premium is the additional return (over and above the risk-free rate) resulting from bearing risk. One of the most significant observations of stock and bond market data is this long-run excess of security return over the risk-free return. –The average excess return from Canadian large- company common stocks for the period 1948 through 2000 was 6.89% = 13.09% – 6.20% –The average excess return from Canadian long-term bonds for the period 1948 through 2000 was 1.58% = 7.78% – 6.20%

9-15 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Risk Premia Suppose that The National Post announced that the current rate for one-year Treasury bills is 5%. What is the expected return on the market of Canadian large- company stocks? Recall that the average excess return from Canadian large- company common stocks for the period 1948 through 2000 was 6.89% Given a risk-free rate of 5%, we have an expected return on the market of Canadian large-company common stocks of 11.89% = 6.89% + 5%

9-16 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited The Risk-Return Tradeoff 6% 8% 2% 4% 10% 12% 14% 16% 18% 0%5%10%15%20%25% Annual Return Standard Deviation Annual Return Average Long Bonds T-Bills Large-Company Stocks

9-17 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Rates of Return

9-18 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Risk Premiums Rate of return on T-bills is essentially risk-free. Investing in stocks is risky, but there are compensations. The difference between the return on T-bills and stocks is the risk premium for investing in stocks. An old saying on Bay Street is “You can either sleep well or eat well.”

9-19 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited U.S. Stock Market Volatility Source: © Stocks, Bonds, Bills, and Inflation 2000 Yearbook™, Ibbotson Associates, Inc., Chicago (annually updates work by Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved. The volatility of stocks is not constant from year to year.

9-20 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 9.5Risk Statistics There is no universally agreed-upon definition of risk. The measures of risk that we discuss are variance and standard deviation. –The standard deviation is the standard statistical measure of the spread of a sample, and it will be the measure we use most of this time. –Its interpretation is facilitated by a discussion of the normal distribution.

9-21 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Normal Distribution A large enough sample drawn from a normal distribution looks like a bell-shaped curve. – 3 – 36.35% – 2 – 19.87% – 1 – 3.39% % % % % Probability Return on large company common stocks 68% 95% > 99% The probability that a yearly return will fall within percent of the mean of percent will be approximately 2/3.

9-22 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Normal Distribution The percent standard deviation we found for stock returns from 1948 through 2000 can now be interpreted in the following way: if stock returns are approximately normally distributed, the probability that a yearly return will fall within percent of the mean of percent will be approximately 2/3.

9-23 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited Normal Distribution Source: © Stocks, Bonds, Bills, and Inflation 2000 Yearbook™, Ibbotson Associates, Inc., Chicago (annually updates work by Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved.

9-24 McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited 9.6 Summary and Conclusions This chapter presents returns for five asset classes: –Canadian Large-Company Common Stocks –U.S. Large-Company Common Stocks –Canadian Small-Company Common Stocks –Canadian Long-Term Bonds –Canadian Treasury Bills Stocks have outperformed bonds over most of the twentieth century, although stocks have also exhibited more risk. The statistical measures in this chapter are necessary building blocks for the material of the next three chapters.