公司金融战略课件

LectureIIntroductiontoCorporateFinanceLearningObjectivesDefinethefieldofcorporatefinanceDescribethethreemajortypesofcorporatefinancialmanagementdecisionsCompareandcontrastthethreedifferentviewofcorporationIdentifytheconflictsofinterestbetweenvariousstakeholders.WhatisCorporateFinanceCorporatefinancefocusesonhowacorporationcancreateandmaintainvalue.InvestmentdecisionsThetimevalueofmoneyCostofcapitalCapitalbudgetingusingNPVCapitalbudgetingunderuncertaintyWhatisCorporateFinanceFinancingdecisionsTherelevanceofcapitalstructureTheoptimalcapitalstructurePayoutpolicyLong-termdebtfinancingIPOManagerialdecisionsWorkingcapitalmanagementShort-termfinancialplanningSpecialtopicsMerge&AcquisitionsRiskmanagementInternationalcorporatefinanceCourseAssessmentTwocases(30%)WorkingroupuptothreestudentsClasspresentationisencouragedFinalExam(70%)Finalexamisclosed-bookCareersincorporatefinanceEntry-LevelPositionsFinancialanalystCreditanalystCashmanagerSeniorpositionsAssistantTreasurerCorporateriskmanagerPensionfundmanagerVerySeniorPositionsChieffinancialofficer(CFO)ThreebasicformsofbusinessorganizationThreemajorformsintheUnitedStatesSoleproprietorshipPartnershipGeneralLimitedCorporationThreebasicformsofbusinessorganizationSoleproprietorship:asingleindividualownsallthefirm’sassetsandresponsibleforallitsliabilities.Thesoleproprietorhasunlimitedliability.Asoleproprietorshipisnotataxentity.Apartnershipissimilartoasoleproprietorshipexceptthattherearetwoormoreowners.Inageneralpartnership,allpartnershaveunlimitedliability.ApartnershipisnotataxentityThreebasicformsofbusinessorganizationCorporation:acorporationislegallya“person”thatisseparateanddistinctfromitsowners,whoareshareholders.Theshareholdershavenodirectliabilityforfinancialobligationsofthecorporation,Incomeistaxedatthecorporatelevel.CorporateformhasseveraladvantagesoverpartnershipsLimitedliabilityPermanencyTransferabilityofownershipBetteraccesstoexternalsourcesofcapitalComparepartnershipandcorporationPartnershipCorporationliabilityFullliabilityLimitedliabilitymanagementPartnershipoperatesthebusinessSeparationofownershipandmanagementTaxentityPartnershippaypersonaltaxCorporationpaycorporatetaxfirst,shareholderspaypersonaltaxfordividendlifeUptopartnership’slifepermanentAccesstoexternalfinancedifficultyeasyTherightsofOwnershipDividendrights:shareholdersgetanidenticalper-shareamountofanydividends.Votingrights:shareholdershavetherighttovoteoncertainmatters,suchastheannualelectionofdirectorsLiquidationrights:shareholdershavetherighttoaproportionalshareofthefirm’sresidualvalueintheeventofliquidation.Preemptiverights:shareholdershavetherighttosubscribeproportionallytoanynewissueofthecorporation’sshare.ThegoaloffinancialmanagementWhatshouldbethegoalofacorporation?Maximizeprofit?Minimizecosts?Maximizemarketshare?Maximizethecurrentvalueofthecompany’sstock?ThegoaloffinancialmanagementMaximizeshareholderwealthWhynotprofitmaximizationProfitmaximizationisvague,therearemanydefinitionsofprofit(accountingprofitvseconomicprofit,shortrunprofitvslongrunprofit,privateprofitvssocialprofit..)IgnoretimevalueofmoneyIgnoreriskSeparationofownershipandcontrolOneoftheadvantagesofcorporationistheseparationofownershipandcontrol,butdomanagersalwaysworkonshareholdersbenefits?Principle-AgencyproblemsManagersmayactintheirownself-interestsAgencycostsreducethevalueofthefirmCorporategovernancefocusonhowtoreduceagencycostsHowshareholdercontrolmanagerialbehaviorShareholdersdetermineboardofdirectors,whointurnselectthemanagementteamShareholderscanusesomeincentiveplan,likestockoptions,orperformanceshare,toencouragemanagerstoworkonshareholders’benefitFearoftakeovergivesmanagersanincentivetotakeactionsthatwillmaximizestockpricesCompetitioninthemanageriallabormarketmayforcemanagerstoperforminthebestinterestorshareholdersTwoDifferentCorporategovernancemechanismBankCapitalMarketFinancialmarketSmall,lessliquidLarge,highlyliquidShareofallfirmslistedsmalllargeOwnershipofdebtandequityconcentrateddispersedDominateagencyconflictControllingvsminoritystakeholdersShareholdersvsmanagementRoleofboardofdirectorslimitedimportantRoleofhostiletake-oversVerylimitedPotentiallyimportantCashFlowbetweenthefirmandthefinancialmarketFirminvestinasset(B)FinancialmarketDebtequityFirmissuesecurity(A)Retainedcashflow(E)Cashflowfromfirm(C)Dividendandinterest(F)taxGovernment(D)FinancialMarkets:FunctionoffinancialmarketsChannelfundsfromsaverswhohaveexcessoffundstolenderswhohaveashortageoffundsfundsurplusunits(savings)funddeficitunits(capitalinvestment)financialintermediariesFunctionoffinancialmarketsAllocationofrisksShiftconsumptionovertheperiodoflifeSeparationofownershipandmanagementImproveinformationalefficiencyTypesofFinancialMarketsMoneymarketismarketfortradingshort-term(usuallylessthanoneyear)securities;Capitalmarketismarketfortradinglong-termsecurities.Capitalmarketincludeslong-termbondmarketandequitymarketAprimarymarketismarketinwhichnewissuesofasecurity,suchasbondorstock,aresoldtoinitialbuyers;thesecondarymarketismarketinwhichsecuritiesthathavebeenpreviouslyissuedcanberesoldFinancialmarketsinU.SNYSEisthelargestsecuritiesexchangesintheworld.NationalAssociationofSecuritiesDealersAutomatedQuotation(NASDAQ)BondmarketLecture2CashFlowandFinancialAnalysisFinancialstatementAccountingStatementsareveryimportantCommunicatewithstakeholdersoutsiderthecompany(shareholders,bonderholders,creditors,IRS,)Monitorthefirm’sactivitiesandevaluatethemanagementperformanceAccountingStatementsarepreparedaccordingtoGAAP(generalacceptedaccountingprinciples).DifferentcountryhasdifferentGAAPIASC(InternationalAccountingStandardCommittee)triestoestablishInternationalFinancialReportingStandards,IFRSBalanceSheetThebalancesheetreportsthefinancialpositionofafirmataparticularpointintime.Assetsaretheproductiveresourcesusedinitsoperation.Liabilityarethetotalclaimsofcreditorsandequityaretheclaimoffirm’sassetthatisresidual.AssetsandLiabilitiesarebrokenintoshort-termandlong-termbasedontheirliquidity.CurrentAssets(Liabilities)matureorexpectedtobepaidoffwithcashwithinoneyear.LongtermassetsandliquidityhavematuritymorethanoneyearAssets=Liability+Stockholder’sequityBalanceSheetNetWorkingCapitalThedifferencebetweencurrentassetsandcurrentliabilityisthefirm’snetworkingcapital.Itmeasuresthefirm’sabilitytomeetitsshorttermobligation.CurrentAssets-CurrentLiabilities=NetWorkingCapitalBalanceSheetBalanceSheetBalancesheetaccountingnumbersarebasedonhistoricalcost,notthetruevalueatcurrenttime.Usersoffinancialstatementsoftenwanttoknowthemarketvalueofthefirm,whichalwaysdiffersfromtheaccountingvalueManyusefulinformationarenotreflectedbyaccountingstatementsIncomeStatementsIncomeStatementsreportstheincome,expenses,andprofitsforafirmoveraspecifictimeinterval,typicallyayearoraquarter.Revenue-Expense=IncomeIncomeisreportedwhenitisearned,oraccrued,eventhoughnocashflowhasnecessarilyoccurredIncomeStatementCashflowfromtheperspectiveoffinanceNoncashitemsThefirmsvalueisbasedonallthecashflowsthefirmcangenerate,nottheaccountingnetincome.Whenestimatingcashflow,weshouldaddbacknoncashitemstothenetincome.ThisprocessiscalledcapitalbudgetingCashflowfromfinancepointofviewCashflowreceivedfromthefirm’sassetsmustequalthecashflowstothefirm’screditorsandequityinvestors.CF(A)=CF(B)+CF(S)Cashflowfromassets=operatingcashflow+capitalspending+changestonetworkingcapitalOperatingcashflow=EBIT-Tax+DepreciationCashflowCashflowtocreditors=interest+changesonlongtermdebtCashflowtoshareholders=dividends+repurchaseofequity-newequityfinancingCalculatingtaxesCashflowshouldberecordedasafter-taxbasisTaxeshaveasignificanteffectonfirm’sdecisionMarginaltaxratevsaveragetaxrateProgressivetaxsystemTaxratesystemUStaxratein200005000015%500007500025%7500010000034%10000033500039%33500010,000,0034%10,000,00015,000,00035%15,000,00018,333,33338%18,333,333>35%TaxRateSystemSupposeyourfirmearns$4millionintaxableincome.Whatisthefirm’staxliability?Whatistheaveragetaxrate?Whatisthemarginaltaxrate?Taxliability:.15(50,000)+.25(75,000–50,000)+.34(100,000–75,000)+.39(335,000–100,000)+.34(4,000,000–335,000)=$1,356,100Averagerate:1,356,100/4,000,000=.339025or33.9025%Marginalratecomesfromthetableanditis34%Lecture3FinancialstatementsAnalysisRatioAnalysisHowitiscomputedWhatisitintendedtomeasureWhatistheunitofmeasurement(times,days,percentage)WhatdoesitmeaniftheratioincreaseordecreaseHowcouldthismeasurebeimprovedRatioanalysisShorttermsolvency:theabilityofthefirmtomeetitsshortrunobligationsActivity:theabilityofthefirmtocontrolitsinvestmentsassetsFinancialleverage-theextenttowhichafirmreliesondebtfinancingProfitability-theextenttowhichafirmisprofitableValue:thevalueofthefirmRatioAnalysisAsingleratiobyitselfisnotverymeaningfulIntra-companycomparisons.(trendanalysis)Industryaveragecomparisons

Inter-companycomparisons(peergroupanalysis)ShorttermsolvencyCurrentratioQuickratioShort-termsolvencyCurrentratiovsquickratio.Considerthefollowingscenario:currentratioarequitestableduringthepastthreeyears,butquickratiodeclinedsteady,howdoesthathappen?FirmmayhavelargeinventoryrelativetocurrentliabilityFirmusecashtopayforinventoryFirmsmayoperatewithlowerlevelofliquidityassetsActivityTotalassetturnoverReceivablesturnoverInventoryturnoverActivityTurnoverratiosdiffersignificantlyduetoNatureofthebusinessCorporatemanagementstrategyOperatingefficiencyFinancialLeverageDebtratioInterestcoverageProfitabilityProfitmarginReturnonAsset(ROA)Returnonequity(ROE)DupontidentityROE=profitmargin*assetturnover*equitymultiplierDupontidentityTheDupontidentityshowsROEisaffectedbythreethingsOperatingefficiency(asmeasuredbyprofitmargin)Assetuseefficiency(measuredbytotalassetturnover)Financialleverage(measuredbytheequitymultiplier)MarketvalueratioP/Eratio=price/EPSThefollowingtableisP/EratioforS&P500indexMarketvalueratiosDividendyieldMarkettobook(M/B)valueTheTobin’sQTobin’sQFirmhasQratiogreaterthan1hasanincentivetoinvestCommonsizefinancialstatementFinancialcharacteristicsofcompaniesvarysignificantlyCommonsizefinancialstatementshowitemsaspercentagesratherthanasamountsofmoneyBalancesheetitemsareexpressedaspercentagesoftotalassetsIncomestatementitemsareexpressedaspercentagesofsalesLimitationoffinancialstatementanalysis1)

Estimates:

Financialstatementscontainnumerousestimates;totheextentthattheseestimatesareinaccurate,thefinancialratiosandpercentagesareinaccurate.2)

Cost:

Traditionalfinancialstatementsarebasedoncostandarenotadjustedforprice-levelchanges.Comparisonsofunadjustedfinancialdatafromdifferentperiodsmayberenderedinvalidbysignificantinflationordeflation.Limitationoffinancialstatementanalysis3)

AlternativeAccountingMethods:

VariationsamongcompaniesintheapplicationofGAAPmayhampercomparability.4)DiversificationofFirms:Manyfirmstodayaretoodiversifiedtobeclassifiedbyindustry,whileothersappeartobecomparablewhentheyarenot.

Lecture3TimeValueofMoneyLearningObjectivesUnderstandtheconceptofnetpresentvalue(NPV)Calculatethepresentandfuturevaluesofanysetofexpectedfuturecashflows,includingannuities,perpetuity.PrepareloanamortizationscheduleChapterscovered:Chapter5,6Time-value-of-moneyTherelationbetweenonedollartodayandonedollarinthefutureiscalledtime-value-of-moneyThetime-value-of-moneycanbeviewedastheopportunitytoearninterestonabanksavingsaccount.FuturevaluesSupposeyouinvest$1000foroneyearat5%peryear.Whatisthefuturevalueinoneyear?Interest=1000(.05)=50Valueinoneyear=principal+interest=1000+50=1050FutureValue(FV)=1000(1+.05)=1050Supposeyouleavethemoneyinforanotheryear.Howmuchwillyouhavetwoyearsfromnow?FV=1000(1.05)(1.05)=1000(1.05)2=1102.50GeneralformulaFV=PV(1+r)tFV=futurevaluePV=presentvaluer=periodinterestrate,expressedasadecimalt=numberofperiodsFuturevalueinterestfactor=(1+r)tCompoundingperiodIfthestatedinterestrateisr,butcompoundingmtimeseachperiod,thenDistinctionbetweenstatedannualinterestrateandeffectiveannualinterestrateContinuoustimecompoundingThepowerofcompoundingLookatthisexample:accordingtoIbboston,theaveragerateofreturninU.S.stockmarketis11.35%,ifyouinvestonedollaratthebeginningof1926,thatonedollarwouldworth$2845attheendof1999.However,ifyoudon’treinvestandwithdraw11.35centsattheendofeachyear,theonedollarwouldonlyworth$8.4attheendof1999.That’swhyreinvestmentcangeneratehugewealthinthelongtermPresentvalueHowmuchdoIhavetoinvesttodaytohavesomeamountinthefuture?FV=PV(1+r)tRearrangetosolveforPV=FV/(1+r)tWhenwetalkaboutdiscounting,wemeanfindingthepresentvalueofsomefutureamount.Whenwetalkaboutthe“value”ofsomething,wearetalkingaboutthepresentvalueunlesswespecificallyindicatethatwewantthefuturevalue.Presentvalue-exampleYouwanttobeginsavingforyourdaughter’scollegeeducationandyouestimatethatshewillneed$150,000in17years.Ifyoufeelconfidentthatyoucanearn8%peryear,howmuchdoyouneedtoinvesttoday?Formula:150,000/(1.08)17=150,000(.270268951)=40,540.34DiscountrateOftenwewillwanttoknowwhattheimpliedinterestrateisonaninvestmentRearrangethebasicPVequationandsolveforrFV=PV(1+r)tr=(FV/PV)1/t–1DiscountrateSupposeyouareofferedaninvestmentthatwillallowyoutodoubleyourmoneyin6years.Youhave$10,000toinvest.Whatistheimpliedrateofinterest?Formula:r=(20,000/10,000)1/6

–1=.122462=12.25%NumberofperiodsStartwithbasicequationandsolvefort(rememberyoulogs)FV=PV(1+r)tt=ln(FV/PV)/ln(1+r)ItissimpleifweassumecontinuoustimecompoundingFV=PV*er*tT=ln(FV/PV)/rNumberofperiodsYouwanttopurchaseanewcarandyouarewillingtopay$20,000.Ifyoucaninvestat10%peryearandyoucurrentlyhave$15,000,howlongwillitbebeforeyouhaveenoughmoneytopaycashforthecar?Formula:t=ln(20,000/15,000)/ln(1.1)=3.02yearsAnnualPercentageRateBydefinitionAPR=periodratetimesthenumberofperiodsperyearConsequently,togettheperiodratewerearrangetheAPRequation:Periodrate=APR/numberofperiodsperyearWhatistheAPRifthemonthlyrateis.5%?.5(12)=6%WhatisthemonthlyrateiftheAPRis12%?12/12=1%EffectiveannualrateThisistheactualratepaid(orreceived)afteraccountingforcompoundingthatoccursduringtheyearEffectiveannualrateSupposeyoucanearn1%permonthon$1investedtoday.WhatistheAPR?1(12)=12%Howmuchareyoueffectivelyearning?FV=1(1.01)12=1.1268Rate=(1.1268–1)/1=.1268=12.68%Supposeifyouputitinanotheraccount,youearn3%perquarter.WhatistheAPR?3(4)=12%Howmuchareyoueffectivelyearning?FV=1(1.03)4=1.1255Rate=(1.1255–1)/1=.1255=12.55%SpecialcashflowpatternAnnuity:anannuityisalevelstreamofregularpaymentthatlastsforafixednumberofperiodsAnapplicationofannuity:installmentdebtcontractSpecialcashflowpatternConsidera$1000loanthatrequiresequalpaymentsattheendofeachofthenext3years.Theinterestrateis10%peryear,whatarethepayments?AmortizingaloanAloanamortizationscheduleshowshowtheloanispaidoffovertime.Becauseaninstallmentloanhasthestructureofanannuity,anamortizationscheduleforsuchaloanshowstherelationshipsamongthepayments,principal,andinterestrate.BuyingahouseYouhaveanannualsalaryof$36,000andthebankiswillingtoallowyourmonthlymortgagepaymenttobeequalto28%ofyourmonthlyincome.Theinterestrateontheloanis6%peryearwithmonthlycompounding(.5%permonth)fora30-yearfixedrateloan.Howmuchmoneywillthebankloanyou?BankloanMonthlyincome=36,000/12=3,000Maximumpayment=.28(3,000)=840PV=840[1–1/1.005360]/.005=140,105SpecialcashflowpatternApersonissavingmoneyforadownpaymentonahouse.Supposehemustsave12000attheendof5years,andtheinterestrateis0.5%permonth,howmuchshouldhesaveeachmonth?PostponedannuitiesSometimes,annuitiesstartatatimeotherthancurrenttime.Fordelayedannuity,weshoulddiscountedfuturecashflowtocurrenttime.Forexample,lifeinsurancepromisetopayyou1000permonthwhenyouare60yearsoldfor20years.Whatisthepresentvalueofthiscontract?(supposeyouarenow30,interestrateis0.5%permonth).PVofa20yearannuityatyear60is139580.8PVoftheannuitynowis23176.26Whatifyouarenow40?PVofthislifeinsurancewouldbe42166SomespecialcashflowpatternPerpetuity:AperpetuityisaconstantstreamofcashflowswithoutendPV=A/r(withoutgrowth)PV=A/r-g(withgrowthrateg)Anapplicationofperpetuity:dividenddiscountmodelDividendDiscountModels:

GeneralModelV0=ValueofStockDt=Dividendk=requiredreturnDividendgrowthmodelwithgrowthLecture4RiskandReturnLearningObjectivesUnderstandthetradeoffbetweenriskandreturnUnderstandthecapitalassetpricingmodel(CAPM)BeabletocomputebetaandexpectedrateofreturnChaptersCovered:Chapter12,13ReturnandRiskRateofreturn:thepercentagegainofholdingsomeassetduringcertainperiodArithmeticaverage:thesumofreturnsineachperioddividedbythenumberofperiodsGeometricaverage:thesingleper-periodreturnthatgivesthesamecumulativeperformanceasthesequenceofactualreturnRisk:thevariationofrateofreturn,measuredasthestandarddeviationofrateofreturn

RateofReturnConventionsforquotingratesofreturn:UsuallyweuseAPR,annualpercentagerateAPR=per-periodrate*periodsperyearSometimesweuseEAR(effectiveannualrate)

Incontinuoustime,EAR=eAPR-1St=S0ert,sorateofreturnequalLn(St/S0)RateofReturn-exampleSupposeyoubuyT-billmaturinginonemonthfor$9,900.HPR=(10000-9900)/9900=1.01%APR=1.01%*12=12.12%EAR=(1+1.01%)12-1=12.82%RiskRiskmeanstheuncertaintyoffutureoutcomeRiskisunobservableFinanceliterateshavedevelopedmanymeasurementsforrisk,thesimplestriskmeasurementisthestandarddeviationofassetreturnExample:ExpectedReturnsSupposeyouhavepredictedthefollowingreturnsforstocksCandTinthreepossiblestatesofnature.Whataretheexpectedreturns?State Probability C TBoom 0.3 15 25Normal 0.5 10 20Recession ??? 2 1RC=.3(15)+.5(10)+.2(2)=9.99%RT=.3(25)+.5(20)+.2(1)=17.7%VarianceandStandardDeviationVarianceandstandarddeviationstillmeasurethevolatilityofreturnsUsingunequalprobabilitiesfortheentirerangeofpossibilitiesWeightedaverageofsquareddeviationsExample:VarianceandStandardDeviationConsiderthepreviousexample.Whatarethevarianceandstandarddeviationforeachstock?StockC

2=.3(15-9.9)2+.5(10-9.9)2+.2(2-9.9)2=20.29=4.5StockT

2=.3(25-17.7)2+.5(20-17.7)2+.2(1-17.7)2=74.41=8.63ThesamplemeanandvarianceTheactualpopulationmeanandvarianceareunknown,wehavetoestimatethesevaluesbysamplingThesamplemeanandvariance

ThesamplecovarianceandcorrelationcoefficientThecovarianceandcorrelationcoefficientmeasurethejointprobabilitydistributionoftwostocksRisk-returntrade-offseriesaverageRiskpremiumriskLargestocks13.3%9.5%20.1%Smallstocks17.6%13.8%33.6%Treasurybond5.5%1.7%9.3%Corporatebond5.9%2.1%8.7%TreasuryBill3.8%3.2%PortfoliosAportfolioisacollectionofassetsAnasset’sriskandreturnareimportantinhowtheyaffecttheriskandreturnoftheportfolioTherisk-returntrade-offforaportfolioismeasuredbytheportfolioexpectedreturnandstandarddeviation,justaswithindividualassetsExample:PortfolioWeightsSupposeyouhave$15,000toinvestandyouhavepurchasedsecuritiesinthefollowingamounts.Whatareyourportfolioweightsineachsecurity?$2000ofDCLK$3000ofKO$4000ofINTC$6000ofKEIDCLK:2/15=.133KO:3/15=.2INTC:4/15=.267KEI:6/15=.4PortfolioExpectedReturnsTheexpectedreturnofaportfolioistheweightedaverageoftheexpectedreturnsforeachassetintheportfolio

Example:ExpectedPortfolioReturnsConsidertheportfolioweightscomputedpreviously.Iftheindividualstockshavethefollowingexpectedreturns,whatistheexpectedreturnfortheportfolio?DCLK:19.69%KO:5.25%INTC:16.65%KEI:18.24%E(RP)=.133(19.69)+.2(5.25)+.167(16.65)+.4(18.24)=13.75%TheriskofaportfolioVariancematrix

Wherexj

istheportfolioweightofeachstockjweightStockxAxBxCxAA

2(A)Cov(A,B)Cov(A,C)xBBCov(A,B)

2(B)Cov(B,C)xCCCov(A,C)Cov(B,C)

2(C)TheportfoliovarianceForaportfoliothathasthreestocksCombinationline:isagraphwhereyouplotE(r)against(r),eachpointonthelineshowsyoutheexpectedrateofreturnandstandarddeviationofaportfoliowithgivenportfolioweightsExampleSupposewehavetwostocks,covarianceiszeroWecancomputetheportfolioexpectedreturnandriskfordifferentweightcombinationoftwostocksABE(r)0.10.04(r)0.050.1XAXBE(rp)(rp)1.5-0.50.130.090.750.250.0850.0450.50.50.070.056-0.51.50.010.152AcombinationlinexA=1.5E(rp)(rp)xA=1.000.040.1xA=-0.5DiversificationPortfoliodiversificationistheinvestmentinseveraldifferentassetclassesorsectorsDiversificationisnotjustholdingalotofassetsForexample,ifyouown50internetstocks,youarenotdiversifiedHowever,ifyouown50stocksthatspan20differentindustries,thenyouarediversifiedTable13.7Figure13.1TotalRiskTotalrisk=systematicrisk+unsystematicriskThestandarddeviationofreturnsisameasureoftotalriskForwell-diversifiedportfolios,unsystematicriskisverysmallConsequently,thetotalriskforadiversifiedportfolioisessentiallyequivalenttothesystematicriskSingleFactorModelri=E(Ri)+ßiF+eßi=indexofasecurities’particularreturntothefactor,ßmeasuresthesensitivityofindividualstockpricemovementtomarketpricemovementF=somemacrofactor;inthiscaseFisunanticipatedmovement;FiscommonlyrelatedtosecurityreturnsForexample,abroadmarketindexliketheS&P500isthecommonfactorMeasuringComponentsofRisk

i2=

i2

m2+

2(ei) where;

i2=totalvariance

i2

m2=systematicvariance

2(ei)=unsystematicvarianceComponentsofRiskMarketorsystematicrisk:riskrelatedtothemacroeconomicfactorormarketindex,can’tbeeliminatedbydiversificationUnsystematicorfirmspecificrisk:risknotrelatedtothemacrofactorormarketindex,sometimescalledfirm-specificrisk,canbeeliminatedbydiversificationTotalrisk=Systematic+UnsystematicTable13.8MeasuringSystematicRiskHowdowemeasuresystematicrisk?WeusethebetacoefficienttomeasuresystematicriskWhatdoesbetatellus?Abetaof1impliestheassethasthesamesystematicriskastheoverallmarketAbeta<1impliestheassethaslesssystematicriskthantheoverallmarketAbeta>1impliestheassethasmoresystematicriskthantheoverallmarketTotalversusSystematicRiskConsiderthefollowinginformation: StandardDeviation BetaSecurityC 20% 1.25SecurityK 30% 0.95Whichsecurityhasmoretotalrisk?Whichsecurityhasmoresystematicrisk?Whichsecurityshouldhavethehigherexpectedreturn?PortfoliobetaandportfolioriskExampleComputeportfolio,suppose(M)=0.1WithmarketindexRisk()weightA-0.50.50.7B0.20.20.3RewardforrisksPuretimevalueofmoney–measuredbytherisk-freerateRewardforbearingsystematicrisk–measuredbythemarketriskpremiumAmountofsystematicrisk–measuredbybetaReward-to-RiskRatio:DefinitionandExampleThereward-to-riskratioistheslopeofthelineillustratedinthepreviousexampleSlope=(E(RA)–Rf)/(

A–0)Reward-to-riskratioforpreviousexample=

(20–8)/(1.6–0)=7.5Ifmarketisefficient,inequilibrium,allassetsgetthesamerewardtoriskratioMarketEquilibriumInequilibrium,allassetsandportfoliosmusthavethesamereward-to-riskratioandtheyallmustequalthereward-to-riskratioforthemarketSecuritymarketlineThecapitalassetpricingmodeldefinestherelationshipbetweenriskandreturnE(RA)=Rf+

A(E(RM)–Rf)Thisequationstatesthattheexpectedrateofreturnonastockisequaltotherisk-freerateplusariskpremium,theriskpremiumitselfcanbebrokenintotwoparts.Theterm[E(rm)-rf]istheriskpremiumformarketportfolio,ortheriskpremiumonaverage;theterm

i,measurestheextenttowhichreturnsonthestockrespondtothereturnsonthemarketportfolio,representingthe