Fundamentals of Finance

Anshul Jain
Returns
• Dollar Returns
the sum of the dividend income Dividends
and the capital gain or loss on the
investment Ending
market value

Time 0 1

Percentage Returns
Initial the sum of the dividend income and
investment the change in value of the asset,
divided by the initial investment.
Returns
Dollar Return = Dividend income + Capital gain (or loss)
Dollar return
Percentage return =
Beginning market value

Dividend + Change in market value over period

=
Beginning market value

= Dividend yield + Capital gains yield

Historical Returns
• A famous set of studies dealing with rates of returns on common
stocks, bonds, and Treasury bills was conducted by Roger Ibbotson
and Rex Sinquefield.
• They present year-by-year historical rates of return starting in 1926
for the following five important types of financial instruments in
the United States:
• Large-company common stocks
• Small-company common stocks
• Long-term corporate bonds
• Long-term U.S. government bonds
• U.S. Treasury bills
Return Statistics
• The history of capital market returns can be summarized by
describing the:
• average return
( R1  ...  RT )
Mean = R 
T
• the standard deviation of those returns

(𝑅1 − 𝑅)2 + (𝑅2 −𝑅)2 + ⋯ + (𝑅𝑇 −𝑅)2

𝑆𝐷 = 𝑉𝐴𝑅 =
𝑇−1
• the frequency distribution of the returns
Historical Returns, 1926-2017
Average Stock Returns and Risk-Free Returns
• The risk premium is the added return (over and above the risk-free rate)
resulting from bearing risk.
• One of the most significant observations of stock market data is the long-run
excess of stock return over the risk-free return.
• The average excess return from large company common stocks for the period 1926
through 2017 was:
8.7% = 12.1% – 3.4%
• The average excess return from small company common stocks for the period 1926
through 2017 was:
13.1% = 16.5% – 3.4%
• The average excess return from long-term corporate bonds for the period 1926 through
2017 was:
3.0% = 6.4% – 3.4%
The Risk-Return Tradeoff

18%
Small-Company Stocks
16%
Annual Return Average

14%

12%
Large-Company Stocks
10%

8%

6%
T-Bonds
4%
T-Bills
2%
0% 5% 10% 15% 20% 25% 30% 35%

Annual Return Standard Deviation

Risk Statistics

• There is no universally agreed-upon definition of risk.

• The measures of risk that we discuss are variance and standard
deviation.
• The standard deviation is the standard statistical measure of the spread of a
sample, and it will be the measure we use most of this time.
• Its interpretation is facilitated by a discussion of the normal distribution.
Normal Distribution - I
• A large enough sample drawn from a normal distribution
looks like a bell-shaped curve.

Probability

The probability that a yearly return

will fall within 19.8 percent of the
mean of 12.1 percent will be
approximately 2/3.

– 3s – 2s – 1s 0 + 1s + 2s + 3s
– 47.3% – 27.5% – 7.7% 12.1% 31.9% 51.7% 71.5% Return on
large company common
68.26% stocks
95.44%

99.74%
Normal Distribution – II
• The 19.8% standard deviation we found for large stock returns from
1926 through 2017 can now be interpreted in the following way:
• If stock returns are approximately normally distributed, the probability that a
yearly return will fall within 19.8% of the mean of 12.1% will be
approximately 2/3.
More on Average Returns

• Arithmetic average—return earned in an average period over a particular

period
• Geometric average—average compound return per year over a particular
period
• The geometric average will be less than the arithmetic average unless all
the returns are equal.
• Which is better?
• The arithmetic average is overly optimistic for long horizons.
• The geometric average is overly pessimistic for short horizons.
Portfolios
• The characteristics of individual securities that are of interest are the:
• Expected Return
• Variance and Standard Deviation
• Covariance and Correlation (to another security or index)

• Individual securities put together form a portfolio, with the following

characteristics

Expected Portfolio Return  (x1 r1 )  (x 2 r2 )

Portfolio Variance  x12σ 12  x 22σ 22  2(x1x 2ρ 12σ 1σ 2 )

The Efficient Set for Two Assets – I
% in stocks Risk Return Portfolio Risk and Return Combinations
0% 8.2% 7.0%
5% 7.0% 7.2%
100%

Portfolio Return
10% 5.9% 7.4% 12.0%

15% 4.8% 7.6% 11.0% stocks

10.0%
20% 3.7% 7.8% 9.0%
25% 2.6% 8.0% 8.0%
100%
7.0%
30% 1.4% 8.2% 6.0% bonds
35% 0.4% 8.4% 5.0%
0.0% 5.0% 10.0% 15.0% 20.0%
40% 0.9% 8.6%
45% 2.0% 8.8%
50.00% 3.08% 9.00% Portfolio Risk (standard deviation)
55% 4.2% 9.2%
60% 5.3% 9.4%
65% 6.4% 9.6%
70% 7.6% 9.8%
75% 8.7% 10.0% We can consider other portfolio
80% 9.8% 10.2%
85% 10.9% 10.4%
weights besides 50% in stocks and
90% 12.1% 10.6% 50% in bonds.
95% 13.2% 10.8%
100% 14.3% 11.0%
The Efficient Set for Two Assets – II
Portfolio Risk and Return Combinations
% in stocks Risk Return
0% 8.2% 7.0%

Portfolio Return
5% 7.0% 7.2% 12.0%

10% 5.9% 7.4% 11.0%

10.0%
15% 4.8% 7.6% 100%
9.0%
20% 3.7% 7.8% 8.0% stocks
25% 2.6% 8.0% 7.0%

30% 1.4% 8.2% 6.0%

5.0%
35% 0.4% 8.4% 0.0% 2.0% 4.0% 6.0% 8.0% 100%
10.0% 12.0% 14.0% 16.0%
40% 0.9% 8.6% bonds
45% 2.0% 8.8% Portfolio Risk (standard deviation)
50% 3.1% 9.0%
55% 4.2% 9.2%
60% 5.3% 9.4%
65% 6.4% 9.6%
70% 7.6% 9.8%
75% 8.7% 10.0% Note that some portfolios are
80%
85%
9.8%
10.9%
10.2%
10.4%
“better” than others. They have
90%
95%
12.1%
13.2%
10.6%
10.8%
higher returns for the same level
100% 14.3% 11.0% of risk or less.
Portfolios with Various Correlations

return
100%
r = -1.0 stocks

r = 1.0
100% r = 0.2
bonds
s
• Relationship depends on correlation coefficient.
-1.0 < r < +1.0
• If r = +1.0, no risk reduction is possible.
• If r = –1.0, complete risk reduction is possible.
The Efficient Set for Many Securities - I

return Individual
Assets

sP
Consider a world with many risky assets; we can still identify the
opportunity set of risk-return combinations of various portfolios.
The Efficient Set for Many Securities – II

return
minimum
variance
portfolio

Individual Assets

sP
The section of the opportunity set above the minimum
variance portfolio is the efficient frontier.
Diversification and Portfolio Risk
• Diversification can substantially reduce the variability of returns
without an equivalent reduction in expected returns.
• This reduction in risk arises because worse than expected returns
from one asset are offset by better than expected returns from
another.
• However, there is a minimum level of risk that cannot be diversified
away, and that is the systematic portion.
Portfolio Risk and Number of Stocks
In a large portfolio the variance terms are
s effectively diversified away, but the covariance
terms are not.
Diversifiable Risk;
Nonsystematic Risk;
Firm Specific Risk;
Unique Risk
Portfolio risk
Nondiversifiable risk;
Systematic Risk;
Market Risk
n
Large Portfolios
• Assume N stocks, portfolio has 1/N invested in each stock
• Variance
• 1/N * Average Variance
• (1 – 1/N) * Average Covariance
• As N increases, effect of Average Variance decreases
• Leads to Diversification
Risk: Systematic and Unsystematic
• A systematic risk is any risk that affects a large number of assets, each
to a greater or lesser degree.
• An unsystematic risk is a risk that specifically affects a single asset or
small group of assets.
• Unsystematic risk can be diversified away.
• Examples of systematic risk include uncertainty about general
economic conditions, such as GNP, interest rates or inflation.
• On the other hand, announcements specific to a single company are
examples of unsystematic risk.
Total Risk
• Total risk = systematic risk + unsystematic risk
• The standard deviation of returns is a measure of total risk.
• For well-diversified portfolios, unsystematic risk is very small.
• Consequently, the total risk for a diversified portfolio is essentially
equivalent to the systematic risk.
Optimal Portfolio with a Risk-Free Asset

return
100%
stocks

rf
100%
bonds

s
In addition to stocks and bonds, consider a world that
also has risk-free securities like T-bills.
Riskless Borrowing and Lending – I

return
100%
stocks
Balanced
fund

rf
100%
bonds
s

Now investors can allocate their money across the T-

bills and a balanced mutual fund.
Riskless Borrowing and Lending – II

return
rf

sP
With a risk-free asset available and the efficient
frontier identified, we choose the capital allocation
line with the steepest slope.
Market Equilibrium – I

return
M

rf

sP
With the capital allocation line identified, all investors choose a point
along the line—some combination of the risk-free asset and the
market portfolio M. In a world with homogeneous expectations, M is
the same for all investors.
Market Equilibrium – II

return
100%
stocks
Balanced
fund

rf
100%
bonds

s
Where the investor chooses along the Capital Market
Line depends on her risk tolerance. The big point is
that all investors have the same CML.
Implications
• All investors hold Market Portfolio and Risk Free Asset
• Systematic Risk is the only relevant risk
• All individual securities lie below the CML
• Unsystematic Risk is not rewarded as it can be diversified
• Market only rewards Systematic Risk
• Hence measurement of Systematic Risk of an individual security
allows us to assess it from an investor’s viewpoint
Risk When Holding the Market Portfolio

• Researchers have shown that the best measure of the risk of a security
in a large portfolio is the beta (b) of the security.
• Beta measures the responsiveness of a security to movements in the
market portfolio (i.e., systematic risk).
• Beta = Correlation of stock & market * std dev of stock / std dev of
market
• Beta = correl*rel risk b 
Cov ( R i , RM )
s ( RM )
i 2
Estimating b with Regression

Security Returns
Slope = bi
Return on
market %

Ri = a i + biRm + ei
The Formula for Beta
Cov(Ri,RM ) s (Ri )
bi  r
s (RM )
2
s (RM )
Clearly, your estimate of beta will depend upon your
choice of a proxy for the market portfolio.


Relationship Between Risk and Expected
Return (CAPM)
• Expected Return on the Market:
R M  RF  Market Risk Premium
 Expected return on an individual security:

R i  RF  β i  ( R M  RF )

Market Risk Premium

This applies to individual securities held within

well-diversified portfolios.
Expected Return on a Security
• This formula is called the Capital Asset Pricing Model (CAPM):

R i  RF  bi  (R M  RF )
Expected
Risk- Beta of the Market risk
return on = + ×
free rate security premium
a security

◦ Assume bi = 0, then the expected return is RF.

◦ Assume bi = 1, then 𝑅𝑖 = 𝑅𝑀
Relationship Between Risk & Return – I - SML

Expected return
R i  RF  bi  (R M  RF )

RM

 RF

1.0 b
Relationship Between Risk & Return – II

Expected return
13.5%

3%
 1.5 b

bi  1.5 RF  3% R M  10%
 R i  3 %  1 .5  (10 %  3 %)  13 .5 %
SML vs CML
• SML
• Return vs Beta
• Expected Security or Portfolio Return given Beta
• CML
• Return vs StDev
• Efficient Portfolios which have maximum return for given total risk
• Not for individual Securities
Estimation of Beta

• Market Portfolio - Portfolio of all assets in the economy. In

practice, a broad stock market index, such as the BSE 500, is
used to represent the market.

• Beta - Sensitivity of a stock’s return to the return on the

market portfolio.
Issues in Estimation of Beta
Cov( Ri , RM )
β
Var ( RM )
• Betas may vary over time.

• The sample size may be inadequate.

• sophisticated statistical techniques

• Betas are influenced by changing financial leverage and business

risk.

• lessened by adjusting for changes in business and financial risk

Stability of Beta

• Most analysts argue that betas are generally stable for firms
remaining in the same industry.

• That is not to say that a firm’s beta cannot change.

• Changes in product line
• Changes in technology
• Deregulation
• Changes in financial leverage
Using an Industry Beta

• It is frequently argued that one can better estimate a firm’s beta by

involving the whole industry.
• If you believe that the operations of the firm are similar to the
operations of the rest of the industry, you should use the industry
beta.
• If you believe that the operations of the firm are fundamentally
different from the operations of the rest of the industry, you should
use the firm’s beta.
• Do not forget about adjustments for financial leverage.
Determinants of Beta

• Business Risk
• Cyclicality of Revenues
• Operating Leverage

• Financial Risk
• Financial Leverage
Cyclicality of Revenues
• Highly cyclical stocks have higher betas.
• Empirical evidence suggests that retailers and automotive firms
fluctuate with the business cycle.
• Transportation firms and utilities are less dependent on the business
cycle.
• Note that cyclicality is not the same as variability—stocks
with high standard deviations need not have high betas.
• Movie studios have revenues that are variable, depending upon
whether they produce “hits” or “flops,” but their revenues may not
be especially dependent upon the business cycle.
• Operating leverage magnifies effect of cyclicality
Financial Leverage and Beta
• Operating leverage refers to the sensitivity to the firm’s fixed costs of
production.
• Financial leverage is the sensitivity to a firm’s fixed costs of financing.
• The relationship between the betas of the firm’s debt, equity, and assets
is given by:

bAsset = Debt × bDebt + Equity × bEquity

Debt + Equity Debt + Equity
• Financial leverage always increases the equity beta relative to the
asset beta.
• Assumption: Beta Debt = 0

• Beta Equity = Beta Asset * (1+D/E)

• Beta Equity = Beta Asset * (1+(1-T)*D/E)

The Cost of Capital

Firm with Shareholder

Pay cash dividend invests in
excess cash
financial asset
A firm with excess cash can either pay a
dividend or make a capital investment

Shareholder’s
Invest in project Terminal
Value
Because stockholders can reinvest the dividend in risky financial assets, the
expected return on a capital-budgeting project should be at least as great as
the expected return on a financial asset of comparable risk.
The Cost of Equity Capital
• From the firm’s perspective, the expected return is
the Cost of Equity Capital:

R s  RF  β ( R M  RF )
• To estimate a firm’s cost of equity capital, we need
to know three things:
1. The risk-free rate, RF
2. The market risk premium, R M  RF
Cov( Ri , RM ) σ i , M
3. The company beta, βi   2
Var ( RM ) σM
The Weighted Average Cost of Capital
Equity Debt
RWACC = × REquity + × RDebt ×(1 – TC)
Equity + Debt Equity + Debt
S B
RWACC = × RS + × RB ×(1 – TC)
S+B S+B

• Because interest expense is tax-deductible, we

multiply the last term by (1 – TC).
• The value of equity and debt to be used are the
market values and not book values
• Typically we assume book value of debt equal to
market value in absence of other information
Firm Valuation

• The value of the firm is the present value of expected future

(distributable) cash flow discounted at the WACC

• To find equity value, subtract the value of the debt from the firm
value