ADMS 3530 Winter 2012 – Professor Lois King
Lecture 9 – Introduction to Risk and Efficient Markets – Mar 6
9.1 Overview of Cost of Capital
− The discount rate ‘r’ has many different names:
o Cost of capital
o Market interest rate
o Opportunity cost of funds
o Yield to maturity (bonds)
o Internal rate of return (if NPV=0)
o Cost of capital – the rate of return that shareholders could expect to earn if they
invested in equally risky securities.
o Market risk premium – the compensation for taking on the risk of common stock
ownership, and can be shown as follows:
Rate of return on common stocks = rate of return on treasury bills +
market risk premium.
− 3 components
o Real rate of return in the economy.
o Rate of inflation
Note: 1 + 2 = the nominal riskfree rate of return or the return you would
expect to receive from investing in a riskfree security such as a Canadian
o Risk premium – which is the return above and beyond the nominal riskfree rate.
The third component is the most difficult to figure out.
− How can we calculate the cost of capital?
o Using historical returns to help calculate cost of capital:
If the project has no risk ▯use the expected Tbill rate of return as our cost
If the project has a risk level equivalent to the market portfolio of common
stock ▯use the expected common stock rate of return as your cost of
9.2 Return & Risk for Individual Securities
− Definitions from Statistics:
o Risk – An increased dispersion of possible outcomes. Where increased volatility
=> increased risk. o Variance – Probabilityweighted average of squared deviations around the
o Expected (or mean) return – Probabilityweighted average of possible outcomes.
− Two types of variance:
o Population variance – Includes all possible outcomes and probabilities are
assigned. The divisor for population variance is ‘n’, versus ‘n1’, as in sample
o Sample variance – Which is used to measure variance in stock returns and sample
populations (no probabilities assigned as probabilities are not usually known).
9.3 Correlation & Diversification
− Volatility (as measured by variance or standard deviation) is a good measure of total risk
of individual securities. However those measures (as calculated for individual securities)