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Basic Corporate Finance 2-208-97 Lecture 9: Risk and CAPM

16 July 2012Tolga Cenesizoglu. 2. The State of Union Address. Our ultimate goal is to find the opportunity cost of capital (i.e. the required rate of return or the discount rate) for project evaluation.The analysis of the relation between return and risk would reveal important information about th

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Basic Corporate Finance 2-208-97 Lecture 9: Risk and CAPM

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    1. Basic Corporate Finance 2-208-97 Lecture 9: Risk and CAPM

    2. 17 July 2012 Tolga Cenesizoglu 2 The State of Union Address Our ultimate goal is to find the opportunity cost of capital (i.e. the required rate of return or the discount rate) for project evaluation. The analysis of the relation between return and risk would reveal important information about the opportunity cost of capital of undertaking a project. Any investment project a firm undertakes must offer a return that is at least as high as the return for similar risk in the financial markets. Otherwise, the investors would choose to invest in the financial markets rather than the firm.

    3. 17 July 2012 Tolga Cenesizoglu 3 What do we know? There is usually a reward for bearing risk, that is, the risk premium. The risk premium is usually larger for riskier investments. The relation between return and risk holds for the aggregate market such TSX and NYSE.

    4. 17 July 2012 Tolga Cenesizoglu 4 Outline for Lecture 9 Review of Statistics Diversification Types of Risk CAPM and Beta

    5. 17 July 2012 Tolga Cenesizoglu 5 Review of Statistics The difference between EXPECTED RETURN and HISTORICAL AVERAGE RETURN: Expected return is the return that the investors expect (based on their current knowledge) over a certain future period. Historical average return is the realized return over a certain past period. The difference between EXPECTED RETURN and REQUIRED RATE OF RETURN: The required rate of return is the amount that investors must receive to compensate them for the risk they are accepting on any given investment.

    6. 17 July 2012 Tolga Cenesizoglu 6 Expected Returns Assume that there are only three possible states of the economy (recession state, normal state and an expansion state). From past experience and your personal beliefs, you expect the economy will be in a recession state 25% of the time, in the normal state 50% of the time and in the expansion state 25% of the time. There are two stocks, A and B with the following returns in different states of the economy.

    7. 17 July 2012 Tolga Cenesizoglu 7 Expected Returns Expected Return of Stock A

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