Return,Risk,andtheSecurityMarketLine

TypesofReturnsExpectedReturnsandVariances Portfolios Announcements,Surprises,andExpectedReturns Risk:SystematicandUnsystematic DiversificationandPortfolioRisk SystematicRiskandBeta TheSecurityMarketLine TheSMLandtheCostofCapital SummaryandConclusionsTypesofReturnsTotalMonetaryreturn=DividendIncome+CapitalGainEganinvestmentof￡1000risesinvalueto￡1500providingacapitalgainof￡500.Overthesameperiodthedividendincomeis5%=￡50.Totalreturnisthen￡500+￡50=￡550.Totalmonetaryreturnisanabsolutemeasureofreturns.Ittellsyouhowmuchmoneyyouhavemadein￡’s.ItisoftenmoreusefultoknowthePercentageReturn.ThePercentageReturnisthetotalmonetaryreturndividedbytheamountofcapitalinvested.PercentageReturn=Dividends+CapitalGains amountinvestedOr Rit=Dit+(Pit–Pit-1)=Div.Yield+%capitalgain

Pit-1ExpectedReturnsandVariances:BasicIdeasThequantificationofriskandreturnisacrucialaspectofmodernfinance.Itisnotpossibletomake“good”(i.e.,value-maximizing)financialdecisionsunlessoneunderstandstherelationshipbetweenriskandreturn.Rationalinvestorslikereturnsanddislikerisk.Considerthefollowingproxiesforreturnandrisk: Expectedreturn-weightedaverageofthedistributionofpossiblereturnsinthefuture. Varianceofreturns-ameasureofthedispersionofthedistributionofpossiblereturnsinthefuture. Howdowecalculatethesemeasures?.CalculatingtheExpectedReturn.

Example1

sE(R)=(pixRi)

i=1

pi Ri

Probability Returnin ipixRi

StateofEconomy ofstateistatei+1%changeinGNP .25 -5%i=1-1.25%+2%changeinGNP .50 15%i=27.5%+3%changeinGNP .25 35%i=38.75%Expectedreturn= (-1.25+7.50+8.75)= 15%CalculatingtheVariance

(Example1ofCalculatingtheexpectedreturn) Var(R)

i (Ri–E(R))2 pix(Ri–E(R))2i=1 (-0.05-0.15)2=0.04 0.25*0.04=0.01i=2 (0.15-0.15)2=0 0.5*0=0i=3 (0.35-0.15)2=0.04 0.25*0.04=0.01Var(R)=.02Whatisthestandarddeviation?

ExpectedReturnsandVariances

Example2

Stateofthe Probability Returnon Returnon

economy ofstate assetA assetBBoom 0.40 30% -5%Bust 0.60 -10% 25% 1.00A. Expectedreturns E(RA)= 0.40x(.30)+0.60x(-.10)=.06=6% E(RB)= 0.40x(-.05)+0.60x(.25)=.13=13%Example:ExpectedReturnsandVariances(concluded)B. Variances Var(RA) = 0.40x(.30-.06)2+0.60x(-.10-.06)2

= .0384 Var(RB) = 0.40x(-.05-.13)2+0.60x(.25-.13)2

= .0216C. Standarddeviations SD(RA) = .0384=.196=19.6% SD(RB) = .0216=.147=14.7%CalculatingExpectedReturnsandVarianceinpracticeThemostcommonmethodistouseatimeseriesofreturnscalculatedfrompastpricesanddividends.dayBPpricediv.Ret.=Ret.Monday4300Tuesday4350(435-430)/4300.0116Wednesday4370(437-435)/4350.0046Thursday4410(441-437)/4370.0092Friday4350(435-441)/441-0.0136Monday4350(435-435)/4350.0000Tuesday4200(420-435)/435-0.0345CalculatingExpectedReturnsandVarianceinpractice(2)E(Ri)isassumedtobeequaltothesampleaveragereturn=(0.0116+0.0046+0.0092-0.0136+0-0.0345)/6=-0.00378Tocalculatethevariancewecalculatethedeviationforeachday’sreturnfromtheexpectedreturn,squaretomakeitpositiveandthendividebyn-1.Inthiscasen=6.CalculatingExpectedReturnsandVarianceinpractice(3)Ret.Rit-E(Rit)(Rit-E(Rit))^20.01160.01540.000240.00460.00840.000070.00920.01290.00017-0.0136-0.00980.000100.00000.00380.00001-0.0345-0.03070.00094-0.003780.00031MeasuringriskIfweweretoplotthedailyreturnsonasecurityoveralongperiodthenitmightlooksomethinglikeanormaldistribution(picturenextslide)Whatwewanttodoistosummarisethispictureassimplyaspossible.Themeanistheexpectedreturn,thespreadorvariationisthestandarddeviationorvariance.WearguethatthisspreadrepresentsrisktoinvestorsandhencethattheSt.Dev.orvarianceisameasureoftheriskofashare.Infactreturndistributionsdon’tusuallylookexactlylikethis.Theytendtohaveatruncatedlefttailandalongerrighttail.Variancemaynotbethebestmeasureofrisk.DescribingadistributionPortfolioExpectedReturnsandVariancesWhatwehavedonesofarisdescribetheriskandreturnofindividualsecurities.Wealsowanttobeabletodescribetheriskandreturnofportfoliosofsecurities.Wehavetwoequivalentalternativesopentous.Component-Wecandeterminethereturnandriskoftheportfoliobycombiningthereturnsandrisksofthesecuritiesthatmakeuptheportfolio.Security-Wecantreattheportfolioasjustanothersecurityandcalculateitsreturnandriskaswehavebeendoing.Bothoftheseapproachesgivethesameanswerbutthefirstallowsustoseehowindividualsecuritiesaffectthereturnandriskofaportfolio.PortfolioExpectedReturnsandVariances

(usingreturnsfromExample2)Portfolioweights:put50%inAssetAand50%inAssetB:StateoftheProbability ReturnReturnReturnon

economyofstateonAonB portfolioBoom 0.4030% -5%12.5%Bust0.60-10% 25%7.5%1.00Example:PortfolioExpectedReturnsandVariances(continued)Calculateexpectedreturns:SecurityapproachE(RP)=0.40x(.125)+0.60x(.075)=.095=9.5%ComponentapproachE(RP)=.50xE(RA)+.50xE(RB)=9.5%Calculatevarianceofportfolio:SecurityapproachVar(RP)=0.40x(.125-.095)2+0.60x(.075-.095)2=.0006PortfolioapproachThesumofthevariancesisnotthevarianceoftheportfolioVar(RP).50xVar(RA)+.50xVar(RB)FtthisweekOlympus–sagacontinues–resignationofPresident,openletterbymajorshareholder,questions(atlast!)byJapanesePressandGovernment.Eurozone–thedeal–moreofthesame,bigger(voluntary)haircuts,moreausteritybutthedebtorstrikesback(Greekreferendum).MFGlobalcollapse–broker-dealersufferingfromeurozoneratingsdowngrades($6.3bnexposure).Managementgreed–hugeincreaseinseniormanagementpayoverlastyear.TheStorysofarOuraimistorelatereturntorisk.Basicprincipleisthatinvestorsrequirearewardfortakingonrisk.Thelargertherisk,thelargerthereward.Buthowarewetomeasureriskandreturn?Manydifferenttypesofrisk.Weconcentrateonriskasperceivedbythecapitalmarkets.Thepriceofashareatanytimereflectseverythingthatisknownaboutthecompany.Suggeststhatwecanusepricechangestoprovideinformationaboutthecompany.Byexaminingthedistributionofpercentagepricechanges(returns)wecandeterminethelikelyorexpectedreturn,andthedispersionofreturnsthatmightoccur.Thestorysofar(2)Anobviousmeasureofexpectedreturnisthearithmeticmean.Ameasureofdispersionisthevariance.Thisisusedasameasureoftheriskofashare.Thevarianceisareasonablemeasureifthedistributionofreturnsissymmetric.Mostcompaniesarenotheldinisolationbutareheldaspartofaportfolio.Weusetwoshareportfoliostodemonstratehowriskchanges.TheproportionofeachcompanyintheportfolioisknownastheportfolioWeight.Ourinterestisinhowonecompanyrelatestoanother.Weareconcernedaboutthejointdistributionofreturns.JointDistributionofreturnsprobabilityReturnonSecurityXReturnonSecurityYCovarianceandCorrelationTheCovarianceisameasureofhowthetwosecuritiesarerelated.SimilartoVariancebutusescrossdeviations.Variance=E(RAt–E(RAt))(RAt–E(RAt))Covariance=average(deviationofreturnonAfromitsmean)*(deviationofreturnonBfromitsmean)CAB=E(RAt–E(RAt))((RBt–E(RBt))CorrelationisastandardisedCovariance.CorrelationbetweenAandBistheCovariancebetweenAandBdividedbythestandarddeviationofAtimesthestandarddeviationofB.AB=CovAB/ABCovarianceandCorrelationTheriskofaportfolioiscomprisedoftheriskoftheindividualsecuritiesplusthecorrelationbetweenthem.Iftherearetwosecuritiesthentheriskoftheportfoliocanbecalculatedfromthevarianceofeachsecurityplusthecorrelationbetweenthem.Fortwosecuritieswehave:p2=X12Var1+X22Var2+2X1X2Cov12Remember:Cov12=1212p2=X1212+X2222+2X1X21212Cov12=E[(R1t-E(R1t))(R2t-E(R2t))]=E[(R2t-E(R2t))(R1t-E(R1t))]=Cov21TwosecurityPortfolioSelectionExampleRpt=X1R1t+X2R2tE(Rpt) =E(X1R1t+X2R2t)=X1E(R1t)+X2E(R2t)p2= E(Rpt-E(Rpt))2p2= E[X1R1t+X2R2t-(X1E(R1t)+X2E(R2t))]2p2= E[X1(R1t-E(R1t))+X2(R2t-E(R2t))]2Fromalgebraweknowthat(a+b)2=a2+b2+2abp2=X12E(R1t-E(R1t))2+X22E(R2t-E(R2t))2+2X1X2E(R1t- E(R1t))(R2t-E(R2t))=X1212+X2222+2X1X2Cov12HowCorrelationaffectsrisk(2securityexample)HowCorrelationaffectsrisk(2securityexample)HowCorrelationaffectsrisk(2securityexample)TheEffectofcorrelationonPortfolioVarianceStockAreturns0.050.040.030.020.010-0.01-0.02-0.03-0.04-0.050.050.040.030.020.010-0.01-0.02-0.03StockBreturns0.040.030.020.010-0.01-0.02-0.03Portfolioreturns:

50%Aand50%BCovarianceandCorrelation:morethan2securitiesOnewayofthinkingofthecovarianceofsecuritieswithinaportfolioistovisualiseamatrixofsecurities.Eachsecuritymustpairwitheachother.Ifthenumbersarethesameitisavariance,otherwiseacovariance.egiftherearefivesecuritieswecanthinkof:security1234511=1variance1,2correlation1,3correlation1,41,522,1correlation2,2variance2,32,42,533,13,23,3Variance3,43,544,14,24,34,4variance4,555,15,25,35,45,5varianceComponentsofPortfolioRiskVarianceCovarianceExpressionCovarianceandCorrelation(cont.)Impactofcorrelation(covariance)SizeofportfolioNumberofvariancesNumberofdistinctcorrelations(covariances)22133355101010451001004950StandardDeviationsofAnnualPortfolioReturns(3)(2) RatioofPortfolio

(1) AverageStandardStandardDeviationtoNumberofStocks DeviationofAnnual StandardDeviation

inPortfolio PortfolioReturns(%) ofaSingleStock149.241.0010 23.930.4950 20.200.41100 19.690.40300 19.340.39500 19.270.391,00019.21 0.39FiguresfromTable1inMeirStatman,“HowManyStocksMakeaDiversifiedPortfolio?”JournalofFinancialandQuantitativeAnalysis22(September1987),pp.353–64,andderivedfromE.J.EltonandM.J.Gruber,““RiskReductionandPortfolioSize:AnAnalyticSolution,”JournalofBusiness50(October1977),pp.415–37.PortfolioDiversificationAverageannualstandarddeviation(%)Numberofstocks

inportfolioDiversifiableriskNondiversifiable

risk49.223.919.21102030401000Diversification:analyticalsolutionDiversification:analyticalsolution(2)Diversification:analyticalsolution(3)Ifweweretolookatthecasewherecovariancesarenotequaltozerowewouldfindthattheriskofalargeportfolioofstocksisapproximatelyequaltotheaveragecovariancebetweenallthestocks.P2CovAVPeterBernsteinonRiskandDiversification“Bigrisksarescarywhenyoucannotdiversifythem,especiallywhentheyareexpensivetounload;eventhewealthiestfamilieshesitatebeforedecidingwhichhousetobuy.Bigrisksarenotscarytoinvestorswhocandiversifythem;bigrisksareinteresting.Nosinglelosswillmakeanyonegobroke...bymakingdiversificationeasyandinexpensive,financialmarketsenhancethelevelofrisk-takinginsociety.”PeterBernstein,inhisbook,CapitalIdeasHowcorrelationaffectsrisk:TheEfficientFrontierFTthisweekOlympus–admitswrongdoing.Eurozone–manyinterestingarticleshighlightingthe‘power’’ofGreece,Germanroleandinterest,dangerstoItalyandothers.Focusononearticle:RobertJenkins,Insight(nov.8)-Greekrestructuring–exitfromtheeurozoneGreekgovtdecidesonexit.Greekcitizensandcompanieswithdraweurodepositswhilsttheyarestilleuros.Foreignlendersstoplendingandrecallloansasquicklyaspossible.Govt.announcesanewdrachma.Capitalcontrolsareintroduced.Govtdebtisredenominatedindrachma.OlympussharepriceFTthisweek(cont)––GreekrestructuringValueofthedrachmaplunges,Greekinflationsoars.Disputesoverprivatesectordebt.Aretheyindrachmaoreuros?Ifdrachmathenforeignbankshaveaproblem––assetvalueshavefallen.IfineurosthenGreekborrowershaveaproblemContagioncommences.Portugesecitizensthinkitmighthappentothemandmoveouteurosfromthebanks.Similarmovesinseveralothercountries.Europeanbanksindifficultiesbecauseofexposuretoeurodebtofvariouscountrieswithlikelydifficulties.Counterpartyriskmeansmarketinbankloansdriesup.Banklendinghalts!BankscollapseunlessGovtrescuethem.TheStorytodateTheriskofaportfoliodependsontheCovarianceorCorrelationbetweenassets.Varianceisimportantforanindividualassetbutbecomeslessandlessimportantasaportfolioincludesmoreandmorestocks.Theriskofaportfoliodependsontheaveragecovariancebetweenstocks.Therelationshipbetweenriskandreturncanberepresentedgraphicallybyaquadraticfrontier.ThebestcombinationsofriskandreturnareontheEfficientFrontier.Theshapeofthefrontierarisesfromthecovariancebetweenassets.HowCorrelationaffectsrisk:ariskfreeassetHowCorrelationaffectsrisk:ariskfreeasset(2)Tobin’sSeparationTheoremSimplifyingourRiskMeasureOurmessagesofarhasbeenthatwhenweaddsecuritiestogetherriskisaffectedbythecorrelation(covariance)betweenthem.Becausesecuritiesarelessthanperfectlycorrelated,riskisreduced.Whilstthisisusefulasaconceptitisoperationallyverydifficulttouse.Thenumberofcorrelationsthatweneedtoconsidertoconstructoptimalportfoliosusingthissortofapproachisverylarge.Weneedtofindsomeothermeasureofriskthatwillenableustosimplifytheproblem.Onesuchmeasureisthebetaofasecurityorportfolio.Thebetaofasecuritycanbethoughtofas:the(standardised)sumofthesecurity’’scovariancewithallsecuritiesSinceallsecuritiesisjustanotherwayofsayingthemarket,thebetaofasecurityis:the(standardised)covarianceofthesecuritywiththemarketEstimatingBetaBetaisusuallyestimatedusinglinearregression.BetaisanoutputfromtheMarketModel.Thisassumesthatthereisalinearrelationshipbetweenthereturnonthemarketandthereturnonashare.Returnsonashareareregressedagainstreturnsonamarketindex.Rit=ai+biRmtcitaiisthealphaofshareIbiisthebetaofshareIBetaCoefficientsforSelectedCompanies(Table10.7)BetaCompany Coefficient(i)Alcatel-Lucent1.44L’Oreal 0.45SAP 0.56Siemens 1.51Daimler 1.25PhilipsElectron 0.92Renault1.64Volkswagen 0.40Source:Hillier,Ross,Westerfield,Jaffe,Jordan.CorporateFinance.PortfolioBetaCalculationsPortfolioBetahasaverydesirablecharacteristic.Itisthe(weighted)averageoftheindividualbetas.Amount PortfolioStock InvestedWeightsBeta(1)(2)(3)(4)(3)x(4)HaskellMfg.$6,000 50% 0.900.450Cleaver,Inc. 4,00033%1.100.367RutherfordCo. 2,00017%1.30 0.217Portfolio $12,000 100%1.034Cash(risklessasset),PortfolioExpectedReturnsandBetasAssumeyouwishtoholdaportfolioconsistingofariskyassetAandcash(arisklessasset).Giventhefollowinginformation,calculateportfolioexpectedreturnsandportfoliobetas,lettingtheproportionoffundsinvestedinassetArangefrom0to125%.AssetAhasabeta()of1.2andanexpectedreturnof18%.ThereturnoncashattheCentralBank(risk-freerate)is7%.AssetAweights:0%,25%,50%,75%,100%,and125%.Cash(risklessasset),PortfolioExpectedReturnsandBetasProportionProportion PortfolioInvestedinInvestedinExpectedPortfolioAssetA(%)Risk-freeAsset(%)Return(%)Beta0 100 7.00 0.0025 75 9.75 0.3050 50 12.500.6075 25 15.250.901000 18.001.20125-2520.75 1.50Plotthisandmeasuretheslope-(.18-.07)/1.2=0.092.Thisistheriskpremiumperunitofsystematicrisk.Cash(risklessasset),PortfolioExpectedReturnsandBetasExpectedreturn18%7%01.2betaSlope=(.18-.07)/1.2=.092Return,Risk,andEquilibriumKeyissues:Whatistherelationshipbetweenriskandreturn?Whatdoessecuritymarketequilibriumlooklike?Thefundamentalconclusionisthattheratiooftheriskpremiumtobetaisthesameforeveryasset.Inotherwords,thereward-to-riskratioisconstantandequaltoE(Ri)-Rfslope=Reward/riskratio=iReturn,Risk,andEquilibrium(concluded)Example:AssetAhasanexpectedreturnof12%andabetaof1.40.AssetBhasanexpectedreturnof8%andabetaof0.80.Aretheseassetsvaluedcorrectlyrelativetoeachotheriftherisk-freerateis5%?a. ForA,(.12-.05)/1.40=________b. ForB,(.08-.05)/0.80=________Whatwouldtherisk-freeratehavetobefortheseassetstobecorrectlyvalued?(.12-Rf)/1.40=(.08-Rf)/0.80Rf=________TheCapitalAssetPricingModelTheCapitalAssetPricingModel(CAPM)-anequilibriummodeloftherelationshipbetweenriskandreturn.Whatdeterminesanasset’’sexpectedreturn?Therisk-freerate-thepuretimevalueofmoneyThemarketriskpremium-therewardforbearingsystematicriskThebetacoefficient-ameasureoftheamountofsystematicriskpresentinaparticularassetTheCAPM:E(Ri)=Rf+[E(RM)-Rf]xiCapitalAssetPricingModel(2)Expectedreturnonassetiisalinearfunctionoftheriskfreerateandtheassetsmarginalrisk(beta)timestheexpectedriskpremiumonthemarket.E(Ri)=Rf+(E(Rm)-Rf)iiisthebetaofasecurity.Itisderivedfromthemarketmodelandrepresentsthemarginalriskofanasset.Theinvestorisassumedtoberational.Assuchtheinvestorwillknowthatbyholdingadiversifiedportfolioofassetss/hecangetridofalltheunsystematicrisk.Theinvestorcan’thowever,getridofthesystematicormarketrisk.Inconsequencetobearmarketrisktheinvestordemandscompensationrelatedtotheamountofmarketrisk.Allassetreturnsarerelatedtotheirrisk.InequilibriumallassetswillplotonthestraightlinegivenrepresentingtheCAPM.ThestraightlineisknownastheSecurityMarketLine.TheCapitalAssetPricingModel:assumptions(3)InvestorsselectefficientportfoliosInvestorshavethesamedecisionhorizonandoverthisperiodmeansandvariancesexist.CapitalMarketsareperfect:Assetsinfinitelydivisible,notransactioncosts,informationiscostlessandavailabletoallNotaxesIndividualscanborrowasmuchoraslittleastheywishatthesameborrowingandlendingrateRfHomogeneousExpectationsandPortfolioOpportunitiesTheSecurityMarketLine(SML)Assetexpected

return(E(Ri))Asset

beta(i)=E(RM)–RfE(RM)RfM=1.0TheCostofCapital:IssuesKeyissues:Whatdowemeanby“costofcapital”Howcanwecomeupwithanestimate?Preliminaries1. Vocabulary—thefollowingallmeanthesamething:a. Requiredreturnb. Appropriatediscountratec. Costofcapital(orcostofmoney)2. Thecostofcapitalisanopportunitycost—itdependsonwherethemoneygoes,notwhereitcomesfrom.3. Fornow,assumethefirm’scapitalstructure(mixofdebtandequity)isfixed.TheWeightedAverageCostofCapitalCapitalstructureweights1. Let:E =themarketvalueoftheequity.D =themarketvalueofthedebt.Then: V=E+D,soE/V+D/V=100%2. Sothefirm’scapitalstructureweightsareE/VandD/V.3. Interestpaymentsondebtaretax-deductible,sotheaftertaxcostofdebtisthepretaxcostmultipliedby(1-corporatetaxrate).Aftertaxcostofdebt=RDx(___________)4. ThustheweightedaveragecostofcapitalisWACC=(E/V)xRE+(D/V)xRDx(1-Tc)Example:EastmanChemical’sWACCEastmanChemicalhas80millionsharesofcommonstockoutstanding.Thebookvalueis$19.10andthemarketpriceis$62.375pershare.T-billsyield5%,andthemarketriskpremiumisassumedtobe8.5%.Thestockbetais1.1.Thefirmhasthreedebtissuesoutstanding.Coupon BookValue MarketValue Yield-to-Maturity6.375%$499m$521m5.70%7.250%$495m$543m6.50%7.625%$200m$226m6.60%Example:EastmanChemical’sWACC(concluded)Costofequity(SMLapproach):RE=.05+1.1x(.085)=.05+.0935=.143514.4%Costofdebt:Multiplytheproportionoftotaldebtrepresentedbyeachissuebyitsyieldtomaturity;theweightedaveragecostofdebt=6.2%Capitalstructureweights:Marketvalueofequity=80millionx$62.375=$4990mMarketvalueofdebt=$521m+$543m+$226m=$1290mV=$4990m+$1290m=$6280mD/V=$1.29/$6.28=.205421%E/V=$4.99/$6.28=.794679%WACC=(.79x.144)+(.21x.062x.65)=.122212.2%Example:TheSMLApproachAccordingtotheCAPM:RE=Rf+Ex(RM-Rf)1. Gettherisk-freeratefromfinancialpress—manyusethe1-yearTreasurybillrate,say6%.2. Getestimatesofmarketriskpremiumandsecuritybeta.a. Riskpremiumhistorical--_________%

b. Beta—historical

(1) Investmentinformationservices-e.g.,Bloomberg(2) Estimatefromhistoricaldata3. Supposethebetais1.40,then,usingtheapproach:RE= Rf+Ex(RM-Rf)= 0.06+1.40x________= ________%CostsofDebtCostofdebt1. Thecostofdebt,RD,istheinterestrateonnewborrowing.2. Thecostofdebtisobservable:a. Yieldoncurrentlyoutstandingdebt.b. Yieldsonnewly-issuedsimilarly-ratedbonds.3. Thehistoricdebtcostisirrelevant--why?Example:Wesolda20-year,12%bond10yearsagoat par.Itiscurrentlypricedat86.Whatisourcostofdebt?Theyieldtomaturityis_______%,sothisiswhatwe useasthecostofdebt,not12%.SummaryofCapitalCostCalculationsTheWeightedAverageCostofCapitalA. TheWACCistherequiredreturnonthefirmasawhole.Itistheappropriatediscountrateforcashflowssimilarinrisktothefirm.B. TheWACCiscalculatedasWACC=(E/V)xRE+(D/V)xRDx(1-Tc)whereTcisthecorporatetaxrate,Eisthemarketvalueofthefirm’sequity,Disthemarketvalueofthefirm’sdebt,andV=E+D.TheSecurityMarketLineandtheWeightedAverageCostofCapitalExpected

return(%)BetaSMLWACC=15%=8%IncorrectacceptanceIncorrectrejectionBA161514Rf=7A=.60firm=1.0B=1.2IfafirmusesitsWACCtomakeaccept/rejectdecisionsforalltypesofprojects,itwillhaveatendencytowardincorrectlyacceptingriskyprojectsandincorrectlyrejectinglessriskyprojects.SummaryofRiskandReturnI. Totalrisk-thevariance(orthestandarddeviation)ofanasset’sreturn.II. Totalreturn-theexpectedreturn+theunexpectedreturn.III.SystematicandunsystematicrisksSystematicrisksareunanticipatedeventsthataffectalmostallassetstosomedegree.Unsystematicrisksareunanticipatedeventsthataffectsingleassetsorsmallgroupsofassets.IV. Theeffectofdiversification-theeliminationofunsystematicriskviathecombinationofassetsintoaportfolio.V. Thesystematicriskprincipleandbeta-therewardforbearingriskdependsonlyonitslevelofsystematicrisk.VI. Thereward-to-riskratio-theratioofanasset’sriskpremiumtoitsbeta.VII.Thecapitalassetpricingmodel-E(Ri)=Rf+[E(RM)-Rf]i.VIII.TheweightedaveragecostofcapitalisWACC=(E/V)xRE+(D/V)xRDx(1-Tc)Readingforthisseriesoflectures(absoluteminimum!)CorporateFinance(Hillieretal)HowtoValueBondsandShares(Ch5)NetPresentValueandOtherInvestmentRules(Ch6)MakingCapitalInvestmentDecisions(Ch7except7.3,7.5)RiskandReturn:L