Introduction to Finance: Understanding Risk and Return

1. Cameron School of BusinessUNIVERSITY OF NORTH CAROLINA WILMINGTON An Introduction to Finance Edward Graham Professor of Finance Department of Economics and Finance

2. Continuing your Introduction to Finance Recalling the Broad Introduction to Finance I. The Three Primary Duties of the Financial Manager II. The Concept of Risk and Return III. Capital Structure Choice

3. An Introduction to Finance What is finance? • Finance is the study of the art and the science of money management; it is based on the Latin root finis, meaning the end.In managing ours or our firm’s money, we consider historical outcomes or “endings,” and we propose future results as a function of decisions made today. Those outcomes or results are typically portrayed using financial statements.

4. The Three Primary Duties of the Financial Manager Whether managing monies for the home, or for the firm, our duties are met with decisions framed by the same general principles. These principles instruct us in making three main types of decisions as we perform those three primary duties: • The capital budgeting decision • The capital structure decision • The working capital decision

5. The Concept of Risk and Return • We are past the half-way point. Celebrate. • Now, back to work! • In Chapter 10, we examine the stock market, not towards learning how to beat it, as that is highly unlikely, but in merely seeking to better understand it. • So, what about the stock market and stock returns? What is a stock return? Recalling the Dividend Growth Model or DGM, we remember that: R = D1/Po + g, or our return is comprised of a dividend yield and a capital gains yield. (p. 292-294) Or, for a $20 share of Duke Energy expected to pay an $.80 dividend and sell for $22 in a year, our expected return becomes: R = .8/20 + .10 = .14

6. The Concept of Risk and Return • A fourteen percent return does not sound thundering, but recalling the rule of 72, that is a return that doubles our money every 5.2 years or so, that beats the stock market averages over the past 50 or so years, and that turns our $20,000 investment today into over $1,000,000 in less than 30 years. (Check it our with your BA II Plus buddies) • Historically, as with your text on page 295, and the table on page 296 (Figure 10.4), we see typical stock and bond performances. • The first lesson on those pages is that with higher returns comes higher risk. • A game-playing example in the next slide illustrates.

7. The Concept of Risk and Return • The Risk Return Relationship Imagine a game, or choice of games: • Game A, you win $100,000 • Game B, you win $10,000,000 two percent of the time, the rest of the time, you win nothing. • Which game do you play? • Expected value of Game A is $100,000 • Expected value of Game B = P(winnning) Winnings + P(losing) Zero Or .02(10 million) + .98 (0) or $200,000 And, 200,000 > 100,000 But, really, do you play Game B?

8. The Concept of Risk and Return • Game B is far riskier, and that introduces our second lesson: • The variability of returns. From chapter 10, we can appreciate the importance of this topic as illustrated on pages 303-308 of your text. • To go for the higher return of Game B, as with a risky stock, we must accept far more risk as illustrated by the variability of Game B’s returns, versus the risk-free guarantee of Game A. • But, in life, there are few guarantees, so if you wish to “take a risk,” recall that the stock market is widely considered to be “efficient.” • There are three versions of an Efficient Market Hypothesis to describe this efficiency: the weak form, the semi-strong form, and the strong form. Each is illustrated by example. (pages 313-315)

9. The Concept of Risk and Return • In Chapter 11, as introduced on pages 323-327, we underscore the ideas of risk and return. • For example, in our game-playing example, we could describe our games’ returns thusly: • Expected Return of Game A = Risk Free (Rf) portion + Risk Premium (RP) • Expected Return of Game B = Rf + Risk Premium, or • E(A) = Rf + RP = 100,000 + 0 • E(B) = Rf + RP = 100,000 + 100,000 • In effect, you are not compensated for risk with Game A, and you get a 100,000 bump in Game B for taking the risk. Further, to not play Game B, in exchange for the guarantee of Game A, you PAY $100,000 in insurance to assure a positive outcome, forgoing the “expectation” of $200,000 with Game B.

10. The Concept of Risk and Return • We extend the tradeoff of being compensated for risk with an investment example: • Suppose we have a risky asset “A,” with expected returns of 100% one-half the time, and a loss of 50% half the time. This is contrasted with an available risk-less or risk-free asset yielding 5%. • E(A) = Rf + RP = .5(100%) + .5(-50%) = 25%. • As we “know” there is a risk-free asset available yielding 5%, our function is: • E(A) = Rf + RP = .05 + .20. We are compensated, or we demand, an additional return of 20% for taking the risk of asset A, for risking that half the time we will lose half our money! • And, to avoid this risk of a single asset, like asset A, we form portfolios.

11. The Concept of Risk and Return • Suppose we have 1 million dollars to invest, in bonds, real estate and stocks. (This is covered in Section 11.2 on page 327 of your text) • We decide to invest $250,000 in bonds yielding 8%, $300,000 in real estate yielding 10%, and $450,000 in stock yielding 12%. These are expected yields, by the way, and not guarantees! We are just hedging our bets by not placing all our money in a single stock or even in a single economic sector! • Our Portfolio’s Expected Return is a weighted average: • E(Rp) = W(b)R(b) + W(re)R(re) + W(s)R(s) = (250,000/1m)(.08) + (300,000/1m)(.10) + (.45)(.12) = .104

12. The Concept of Risk and Return We achieve a reduction in our portfolio’s variance as in Table 11.7 on page 335 and Figure 11.1 on page 336 with this portfolio. In an environment with a t-bill or other risk-free asset yielding 3%, our risk premium with this portfolio would be 7.4%. We avoid, with this portfolio, most of the shock to any one sector or industry (called non-systematic or non-economy-wide risk), but with any risky investment or risky portfolio we still have systematic or economic risk. (As on page 333 of your text in Section 11.3). With diversification, we get rid of most of the unsystematic or diversifiable risk, but we can only get rid of the economy-wide or non-diversifiable risk with t-bills or certificates of deposit.

13. The Concept of Risk and Return • A model exists, Section 11.7 on pages 341-348 of your text, called the Capital Asset Pricing Model or CAPM that describes the nature of risky asset returns as a function of a risk-free guarantee, a risk-premium and the systematic risk of the asset in question. • We describe security expected returns or E(R)’s as the sum of a Risk-free return and a Risk Premium. • E(R) = Rf + Bi [ E(Rm) – Rf ], defining each term as in Table 11.9 on page 348. Bi is a measure of systematic or economy-wide risk – it is the measure of the exposure of McDonald’s stock to the whole economy, for example, and not just beef prices (that is an example of non-systematic risk). The portion “Bi[E(Rm) – Rf]” is the Risk Premium. Rm is the expected return on the market, like the S and P 500 stock index, for example. • The CAPM “story” is told with the Security Market Line or SML, as in your text on page 347. The SML is the central prediction of the CAPM.

14. The Capital Structure Decision With the capital structure decision, the financial manager decides from where best to acquire monies long-term. The purchase of that new delivery truck with cash or with a loan from GMAC or Ford Motor Credit is a capital structure decision; the use of long-term borrowing to fund a franchise purchase is another. Perhaps most importantly, the decision to fund a firm’s growth with equity - such as with funds invested by the firm’s founders, angel investors, venture capitalists or public stock offerings – or debt, is a critical capital structure choice. Two features of this choice bear mentioning: • The risk of the debt • The loss of control and reduced potential cash flows to the founders with an equity or stock sale We expand our review with a few capital structure decisions.

15. The Capital Structure Decision • Recall that our overall objective as financial managers is to “borrow” money at one rate of interest (letting that borrowing cost be an assembly of our debt costs and our stockholders’ expected returns), invest that money at a higher rate of return, and “keep the difference. In this case, we keep the difference on behalf of our shareholders and towards elevating our stock price. • Table 12.1 on page 373 captures the spirit of the costs of capital material in Chapter 12. There, we see that our “borrowing cost” above becomes this curious weighted average cost of capital or: • WACC = (E/V)Re + (D/V)Rd(1-Tc) or our WACC is simply the market-valued weighted average of each of our debt and equity funding levels times the respective costs of each of those funding sources. The debt costs are reduced to the after-tax level of expense as interest is tax deductible, but dividends and capital gains earned by shareholders are not.

16. The Capital Structure Decision: An Example WACC = (E/V)Re + (D/V)Rd(1-Tc), with the factors defined. E is the market value of outstanding equity V is the market value of the firm, E + D Re is the required return on equity using the DGM or CAPM D is the market value of outstanding debt Rd is the pre-tax cost of borrowing, typically the YTM on the firm’s bonds, or other published borrowing costs Tc is the marginal tax rate of the firm

17. The Capital Structure Decision: An Example (continued) WACC = (E/V)Re + (D/V)Rd(1-Tc), Tc, the tax rate, is 40% Suppose a firm has 100 million shares of stock outstanding trading at $50, E is just 50 x 100m or $5 billion. Assume also the firm has 3 million 8% bonds outstanding trading at $950. They have ten years to maturity, and pay an annual coupon. D is $950 x 3m or $2.85 billion. V = D + E = $5 billion + $2.85 billion = $7.85 billion YTM? 1,000 FV, 80 PMT, 10 N, -950 PV, CPT I/Y = 8.77% Re? Suppose the firm uses the CAPM (the firm could just as easily use the DGM or some other method to estimate its costs of equity), its beta is 1.2, treasury bills are yielding 1%, and the expected market return is 8%. Re = Rf + Bi(Rm–Rf) = .01 + 1.2(.08 - .01) = .01 + .084 = 9.4%

18. The Capital Structure Decision: An Example (continued) WACC = (E/V)Re + (D/V)Rd(1-Tc) E = $5b, D = $2.85b, V = $7.85b E/V = the equity weight = (5/7.85) = .637, D/V = the debt weight = (2.85/7.85) = 1 - .637 = .363 Rd = YTM = I/Y = 8.77% = .0877 Re = 9.4% (from the CAPM) = .094 Tc is still 40% or .4 WACC = (.637).094 + (.363).0877(.6) = .06 + .019 = 7.9% What does this 7.9% WACC actually mean? It is the suggested discount rate (NPV) or hurdle rate (IRR) that the firm should use with “typical” projects of average risk for the firm. The WACC has clear theoretical extensions to such theories as the static tradeoff theory or the pecking order theory of capital structure.