Introduction to Corporate Finance

PART 2: VAlUATION, RISK AND RETURN

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

calculate an investment’s total return

in dollar or percentage terms, identify

the components of the total return and

explain why total return is a key metric for

assessing an investment’s performance

describe the historical performance of

asset classes such as Treasury bills, Treasury

bonds and ordinary shares, and articulate

the important lessons that history provides

calculate the standard deviation from a

series of historical returns

distinguish between systematic and

unsystematic risk, explain why systematic

risk is more closely linked to returns than

is unsystematic risk and illustrate how

diversification reduces volatility.

LO6.1

LO6.2

LO6.3

LO6.4

Finance teaches that investment returns are related

to risk. From a purely theoretical perspective, it

seems logical that risk and return should be linked,

but the notion that an unavoidable trade-off

between the two exists is grounded in fact. In

countries around the world, historical capital market

data offer compelling evidence of a positive relation

between risk and return. That evidence is a major

focus of this chapter.

In chapters 4 and 5, we argued that corporate

bonds are more risky than Treasury securities

and that ordinary shares are riskier than either

corporate or Treasury bonds. Based on that

assessment, we should expect a relationship such

as that shown in Figure 6.1. If we arrange these

assets from least to most risky, we expect returns

to rise, as we move from left to right in the figure.

Soon, we will see that this is exactly the pattern

revealed by historical data.

Perhaps the most important question in finance

is, ‘What is it worth?’ For an investor contemplating

a share purchase, or for a corporate manager

weighing a new plant construction proposal, placing

a value on risky assets is fundamental to the

FIGURE 6.1 THE TRADE-OFF BETWEEN RISK AND RETURN

Intuitively, we expect that investors seeking higher returns must be willing to accept higher risk. Moving along the line

from safe assets such as Treasury notes to much riskier investments such as ordinary shares, returns should rise.

(^0) Risk
Return
Treasury notes
Treasury bonds
Investment
grade bonds
Junk bonds
Corporate bonds
Ordinary shares