6: The Trade-Off Between Risk and Returndecision-making process. The procedure for valuing
a risky asset involves three basic steps:
1 determining the asset’s expected cash flows
2 choosing a discount rate that reflects the
asset’s risk
3 calculating the present value.
Finance professionals apply these three steps,
known as discounted cash flow (DCF) analysis, to
value a wide range of real and financial assets.
Chapter 3 introduced you to the rather mechanical
third step of this process – converting a sequence
of future cash flows into a single number reflecting
an asset’s present value. Chapters 4 and 5
focused more on the first step in the process –
projecting future cash flows. In this chapter and
in Chapter 7, we will emphasise the second step
in DCF valuation – determining a risk-appropriate
discount rate.
We begin by establishing a precise measureof an investment’s performance called the total
return. An asset’s total return captures any income
that it pays as well as any changes in its price.
With the definition of total return in hand, we
proceed to study the historical performance of
broad asset classes such as shares and bonds.
Our analysis examines both the nominal and real
returns that different investments have earned
over time. Because inflation gradually erodes
the value of a dollar, we focus on the real returns
offered by various asset classes, not just their
nominal returns. When people save their money
and invest it, they do so in the hope of living
more comfortably in the future. Their objective
is not just to accumulate a large sum of money,
but to be able to spend that money to buy the
necessities (and the luxuries) of life. Real returns
matter because they measure the increase in
buying power that a given investment provides
over time.
All of this is relevant for financial managers,
because they work on behalf of the investors who
provide money to corporations. Therefore, for
managers to make value-maximising decisions
when they consider building a new plant, upgrading
machinery or launching a new product line, they
have to assess each investment project’s risk and
then choose a discount rate that reflects the return
that investors could obtain on similar investments
elsewhere in the market. Choosing a discount rate
to value a specific asset requires answers to two
critical questions:1 How risky is the asset, investment or project that
we want to value?
2 How much return should the project offer, given
its risk?This chapter addresses the first question, showing
how different ways of defining and measuring
risk apply to individual assets as compared with
portfolios (collections of different assets). Since the
US market is the market that is most heavily studied,
it is the market with the greatest abundance of
research and data. In this chapter, we have drawn
on this data to illustrate the theoretical concepts
and principles associated with the trade-off
between risk and return. However, these concepts
and principles are applicable to all markets. To
illustrate this, we have augmented the US data with
domestic Australian data.
Building on this foundation, Chapter 7 will
provide an answer to the second question. The
capital asset pricing model (CAPM) proposes a
specific way to measure risk and to determine what
compensation the market expects in exchange for
that risk. By quantifying the relationship between
risk and return, the CAPM supplies finance
professionals with a powerful tool for determining
the value of financial assets such as shares, as well
as real assets such as new factories and equipment.