Textbook Notes (363,559)
Canada (158,426)
Economics (800)
ECON 2560 (71)
Chapter 11

Chapter 11 ECON 2560

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University of Guelph
ECON 2560
Tahsin Mehdi

Chapter 11 ECON 2560 Introduction to Risk, Return, & the Opportunity Cost of Capital RATES OF RETURN: REVIEW  When investors buy a stock or bond, their return comes from either (a) a dividend or interest payment & (b) a capital gain or capital loss Percentage Return = Capital Gain + Dividend Initial Share Price Dividend Yield = Dividend___ Initial Share Price Percentage Capital Gain = Capital Gain___ Initial Share Price Divided Yield + % Capital Gain = Total Percentage Return  The nominal rate of return measures how much money you will have at end of the year if you invest today  The real rate of return tells you how much more you will be able to buy w/ your money at end of year To convert nominal to real rate…. 1 + real rate of return = 1+ nominal rate of return 1 + Inflation Rate EIGHTY-FIVE YEARS OF CAPITAL MARKET HISTORY  When you invest in a stock… you don’t know how much return you’ll earn  By looking at history of security return, you can get some idea of the return investors might expect & risks they face Risks that investors have experienced in the past… Market Indexes  Investors choose from a large number of different securities (common shares, preferred shares, income trust units, etc.)  Financial analysts cant track every stock so they use market indexes to summarize the return on different classes of securities Market Index: Measure of the investment performance of the overall market  The main stock market index in Canada is the S&P/TSX Composite Index, based on a portfolio of the largest TSX stocks  To be included in index, stocks must meet size & trading activity minimums  It’s a Value-weighted index measuring the performance of a portfolio calculated as if all shares of each stock are owned and so weight on each stock equals the ratio of its market capitalization ( # shares x price per share) to the sum of the market capitalization of all stocks in the portfolio  An Equal-weighted index measures the performance of a portfolio consisting of 1 share of each stock (shows average performance of investors in the stocks)  Every day the index is calculated by multiplying the current share prices by / of outstanding shares and then this number is divided by the original value of the index and multiplied by 1000 S&P/TSX Composite Total Return Index: Measure of the composite index based on the prices + dividends paid by the stocks in the S&P/TSX Composite Index  The best known stock market index in U.S is the Dow Jones Industrial Average(Dow) which tracks the performance of a portfolio that holds 1 share in each of 30 large firms  The stock of such high-quality, stable firms is sometimes called `blue-chip`  Not the best measure of performance in the U.S stock market b/c it’s not representative and is an equal-weighted index Standard & Poor`s Composite Index: U.S Index of the investment performance of a portfolio of 500 large stocks (Also called S&P 500)  More comprehensive index than Dow The Historical Record  The historical returns of stock or bond market indexes can give us an idea of the typical performance of different investments Using data prepared by the Canadian Institute of actuaries & Stats Canada we can measure investment performance of 3 portfolios of securities since 1925… 1. A portfolio of 91-day gov`t securities (Treasury bills)  Treasury bills are probably safest investment you can make b/c they`re issued by the Fed. Government you can be sure you’ll get money back & short-term maturity means prices are pretty stable 2. A portfolio of long-term Canadian gov`t bonds  Certain to be repaid when mature BUT prices of these bonds fluctuate more as interest rates vary (When interest rates fall, value rise & vice-versa) 3. A portfolio of stocks of large Canadian companies  Common stocks are most risky  No promise you`ll get money back, you receive whatever is left after the bonds & any other debt have been repaid Maturity Premium: Extra average returns from investing in long-term bonds vs. short-term treasury securities  Common stocks were in a class by themselves Risk Premium: Expected return in excess of risk-free return as compensation for risk Rate of return on common stocks = Interest rate on treasury bills + market risk premium  Investors who accepted the risk of common stocks received on avg. an extra return of 6.9% a year over return on treasury bills  The historical risk premium for long-term gov`t bonds portfolio is only 1.9% b/c it is less risky Using Historical Evidence to Estimate Today`s Cost of Capital  The opportunity cost of capital is the return given up by investing in the project rather than in comparable risk alternatives  A firm should invest in a risk-free project only if it can at least match the rate of interest on such a loan  If project is risky firm needs to at least match the return that could be expected to be earned if they invested in securities of similar risk  Not easy to put a precise figure on this but can skim through history to get an idea of average return an investor might expect to earn from investment in risky common stocks  Estimating the project`s cost of capital is done by estimating the currently expected rate of return on the other option MEASURING RISK  You need some measure of how far the returns may differ from the average  One way to present the spread of possible investment return is
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