Week 9 - Decc01
Week 9 - Decc01
Week 9 - Decc01
Corporate Finance
Chapter 7: Introduction to Risk and Return
We need to look back over a long period of time like this to measure average rates of return, because
the annual rates of return for common stocks fluctuate so much that averages over short periods are
meaningless.
→ The only way to gain insights from historical rates of return is to look at very long periods.
Arithmetic Averages
If the cost of capital is estimated from historical returns or risk premiums, we should
use arithmetic averages, and not compound annual rates of return.
∑𝑃𝑜𝑠𝑠𝑖𝑏𝑙𝑒 𝑟'𝑠
𝑟 (1 𝑦𝑒𝑎𝑟) = 𝑁º 𝑝𝑜𝑠𝑠𝑖𝑏𝑙𝑒 𝑟'𝑠
We cannot assume that the expected rate of return will be like the same and use
averages calculated in the past, because they’re not likely to stay stable overtime.
We assume that the normal risk premium is stable, and that it can be measured by past
averages, but it’s hard to estimate it exactly and to make sure that the investors are
demanding the same rate of return today.
Reasons why the risk premium may be overstating investors’ demand today:
If there has been a downward shift in the return that investors have required, then past
returns will provide an overestimate of the risk premium.
1. Historical risk premium reflects past political and economic risks that are way
more stable and less likely to happen today. This means that investors today don’t
expect such a high rate of return because their profit is way more secured.
2. A rise in stock prices can come from a fall in the risk premium, and if we use this
price rise in ours measures of past returns, we may be:
- Overestimating the return that investors required in the past
- Failing to recognize that the return investors require in the future is lower
than in the past
If stock prices are expected to keep pace with the growth in dividends, then the
expected market return is equal to the dividend yield plus the expected dividend growth:
𝐷𝐼𝑉1
𝑟= 𝑃0
+ 𝑔
Should investors adjust cost of capital to reflect the fluctuations in dividend yields?
This means that very little of the variation is related to the subsequent g, which means
that the level of yield tell us about the return that investors require.
→ A reduction in the dividend yield means a reduction in the risk premium that investors
expect over the following years
So, when yields are relatively low, companies may be justified in shaving their estimate
of required returns over the next year or so, although when estimating the discount rate
for longer-term investment the year-to-year fluctuations in the dividend yield can be
ignored.
To know how to estimate discount rates for assets that don’t fit simple cases (safe and
average-risk projects) we need to know:
Variance and standard deviation are used to summarize the spread of possible
outcomes of the risk of an asset, so they’re natural indexes of risk.
Measuring Variability:
It’s possible to compare past variability with present, since it’s reasonable to assume
that portfolios with histories of high variability also have the least predictable future
performance.
→ Treasury bills have the least variable security, common stocks are the most variable,
and government bonds hold the middle ground.
Also, the market variability depends on each country economic and political
environmental and the period of time of the security:
For the most part, individual stocks are more variable than the market indexes. So, why
doesn’t the variability of the market portfolio reflect the average variability of its
components? Because diversification reduces variability, even when it’s done in a low
amount.
> If two invested stocks move in the opposite direction, the risk of one is
compensated by the profitability of the other, reducing standard deviation.
The risk that can be eliminated by diversification is called specific risk: it comes from
the fact that many of the perils that surround an individual company are peculiar to that
company and perhaps its immediate environment and competitors.
But there’s also risk that can’t be avoided or diversified, which is the market risk: it
comes from the fact that there are economywide perils that threaten all businesses.
Therefore stocks have a tendency to move together and investors are always exposed to
market uncertainties, no matter how many stocks they hold.