Evaluating Risk

Danger (Risk) and Opportunity

(Expected Return)
 Maximize the Value of the Business
(Firm)

The Investment The Financial The Dividend

Decision Decision Decision
Invest in assets that Find the right kind of If you cannot find
earn a return greater debt or your firm and investments that
than the minimum the right mix of debt make your minimum
acceptable hurdle and equity to fund acceptable rate,
rate your operations return the cash to
owners of your
The hurdle The The The right business
How much How you
rate return optimal kind of cash you choose to
should reflect should mix of debt can return return
The riskiness reflect the debt and matches depends on cash to
of magnitude equity the tenor current and the
the and the maximizes or your potential owners
investment timing of firm value assets investment will
and the mix the cash opportuniti depend on
of debt and flows as es whether
equity used well as all they
to fund it side prefer
effects dividends
or
buybacks
 Probability = 1

Expected Retur
Return ns

Returns on a Risk-free investment

 The greater the deviation of
the actual returns from
expected returns, the greater
the variance hence more
area under the curve.

Expected Retur
Return ns

Probability Distribution for Risky

investment
 Low variance investment

High variance
investment

Expected
Return
Return Distribution
Comparison
 Adjusted Closing prices of IBM
250

200

150
Adj Close

100

50

Returns of IBM
0.15

0.1

Returns
0.05

-0.05

-0.1
Calculation of Risk using Historical
Returns-- IBM

(Price t Price t 1 Dividends t )

Return t
Price t 1

t n
(R t Average return) 2
Semi variance
t 1 n
Q. Unicom is a regulated utility serving northern Illinois. The
following table lists the stock prices and dividends on Unicom
from 1989 to 1998.
Years Price Dividends
1989 $36.10 $3.00
1990 33.60 3.00
1991 37.80 3.00
1992 30.90 2.30
1993 26.80 1.60
1994 24.80 1.60
1995 31.60 1.60
1996 28.50 1.60
1997 24.25 1.60
1998 35.60 1.60

Required: (a) Estimate the average annual return you would have
made on your investment.
(b) Estimate the standard variance and variance in annual returns.
 A Breakdown of Risk
Projects Competition Interest
may do may be Entire Exchange rates,
better or Investing
Firms sector
weaker Acquirin
or may
DiversifyingrateDiversify
and inflation
Cannot
canworse in many stronger
g be affected
across political
ing and news
affect
than projectsthan competit
reduce by action
sectors risk
across about
byexpected anticipated
ors countrie economy
s
Investor Diversifying across Diversifying Diversifying
s can domestic stocks globally across asset
mitigate classes
Firm
by
Specific Mark
et
Actions or
risk that Actions/
affect only risk that
one firm affect all
Affects few Affects
investmen
firms many firms
ts
 Limits of Diversification
Total Risk = Un-diversifiable risk +
Total Risk (Variance) of Portfolio

Diversifiable risk
Total Risk

Unique risks
(unsystematic)

Market risks
(systematic)

Number of securities
 Beta () of an Asset
The Beta of an asset, is a market-sensitivity measure
It is a measure of the variability of that asset relative to the
variability of the market as a whole
Thus it is an index of the systematic risk of an asset.

Covariance of asset i with market portfolio

Beta of an asset i
Variance of the market portfolio

Covi m
i
m2
 Capital Asset Pricing Model
(CAPM)
According to CAPM, the expected return on an asset, i, is related to
the risk of the asset as follows:-

E ( Ri ) R f i [ E ( Rm ) R f ]
Where,
E(Ri) = Expected rate of return on asset i, or the assets RRR

Rf = Risk-free rate of return

i = Beta coefficient of stock I

E(Rm) = Expected return on the market portfolio (S&P 500)

Q. The Baldwin-Mills Corporation has a beta of 1.25 and pays
no dividends. The expected market return is 20%, and T-bill
rate is expected to remain constant at 10%. You expect
Baldwin-Mills shares to be worth $50 in one year. Using the
CAPM, find the value of a share today.

Q. Saldco shares have a beta of 1.2, are currently selling for

$80 each and pay no dividends. The risk-free rate is 10%, and
the expected market return is 16%.
(a) What do you expect Saldco shares to trade for one year
from today?
(b) If the expected market return is 20% (rather than 16%),
what do you expect Saldco shares to trade for one year
from today?