Fina

CHAPTER 2

Risk and Return: Part I

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Topics in Chapter

Basic return concepts

Basic risk concepts

Stand-alone risk

Portfolio (market) risk

Risk and return: CAPM/SML

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Determinants of Intrinsic Value:

The Cost of Equity

Net operating

profit after taxes

Free cash flow

(FCF)

Value =

Required investments

in operating capital

−

=

FCF1

FCF2

FCF∞

+

+ ... +

(1 + WACC)1

(1 + WACC)2

(1 + WACC)∞

Weighted average

cost of capital

(WACC)

Market interest rates

Cost of debt

Firm’s debt/equity mix

Market risk aversion

Cost of equity

Firm’s business risk

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What are investment returns?

Investment returns measure the

financial results of an investment.

Returns may be historical or prospective

(anticipated).

Returns can be expressed in:

Dollar terms.

Percentage terms.

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An investment costs $1,000 and is

sold after 1 year for $1,100.

Dollar return:

$ Received - $ Invested

$1,100

- $1,000

Percentage return:

$ Return/$ Invested

$100/$1,000

= $100.

= 0.10 = 10%.

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What is investment risk?

Typically, investment returns are not

known with certainty.

Investment risk pertains to the

probability of earning a return less than

that...