Class 9 Financial Management, 15
Risk and return (1)
Class 9
Financial Management, 15.414
15.414
MIT SLOAN SCHOOL OF MANAGEMENT
Today
Risk and return
? Statistics review
? Introduction to stock price behavior
Reading ? Brealey and Myers, Chapter 7, p. 153 ? 165
Class 9
15.414
MIT SLOAN SCHOOL OF MANAGEMENT
Road map
Part 1. Valuation
Part 2. Risk and return
Part 3. Financing and payout decisions
Class 9
3
15.414
MIT SLOAN SCHOOL OF MANAGEMENT
Cost of capital
Class 9
DCF analysis
NPV
=
CF0
+
CF1 (1+ r)
+
CF2 (1+ r)2
+
CF3 (1+ r)3
+
CF4 (1+ r)4
+
CF5 (1+ r)5
+ ...
r = opportunity cost of capital The discount rate equals the rate of return that investors demand on investments with comparable risk.
Questions
How can we measure risk?
How can we estimate the rate of return investors require for projects with this risk level?
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15.414
MIT SLOAN SCHOOL OF MANAGEMENT
Examples
Class 9
In November 1990, AT&T was considering an offer for NCR, the 5th largest U.S. computer maker. How can AT&T measure the risks of investing in NCR? What discount rate should AT&T use to evaluate the investment?
From 1946 ? 2000, small firms returned 17.8% and large firms returned 12.8% annually. From 1963 ? 2000, stocks with high M/B ratios returned 13.8% and those with low M/B ratios returned 19.6%. What explains the differences? Are small firms with low M/B ratios riskier, or do the patterns indicate exploitable mispricing opportunities? How should the evidence affect firms' investment and financing choices?
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