Introduction to Corporate Finance

PART 2: VALUATION, RISK AND RETURN

SUMMARY

■ Investors and managers make decisions based

on expected returns.

■ Estimates of expected returns may be obtained

from historical data, from probabilistic

calculations or from a risk-based approach.

■ An asset’s beta measures its systematic risk,

and it is this risk that should be linked to

expected returns.

■ The expected return of a portfolio equals a

weighted average of the expected returns of

the assets in the portfolio. The same can be

said of the portfolio’s beta.

■ The standard deviation of a portfolio usually

does not equal the weighted average of the

standard deviation of the shares in the portfolio.

This is because some of the unsystematic

fluctuations of individual shares cancel each

other out in a portfolio. A fully diversified

portfolio contains only systematic risk.

■ A portfolio’s expected return, standard

deviation and beta can be calculated using

Equations 7.1, 7.2, 7.3 and 7.4, respectively,

in the ‘Table of important equations’ below.

■ The CAPM predicts that the expected return

on a share depends on the share’s beta, the

risk-free rate, and the market risk premium.

■ Equation 7.5 in the ‘Table of important

equations’ shows how the capital asset

pricing model (CAPM) links an asset’s beta to

its expected return.

■ According to the efficient markets hypothesis

(EMF), competition in financial markets creates

an equilibrium in which it is very difficult to

identify overvalued or undervalued assets,

because all financial asset prices rapidly and

fully incorporate all new information.

■ In an efficient market, competition for

information makes asset prices nearly

unpredictable.

LO7.1

LO7.2

LO7.3

LO7.4

IMPORTANT EQUATIONS

7.1 E (rp) = w 1 E (r 1 ) + w 2 E (r 2 ) +.. .+ wn E (rn)

where w 1 + w 2 +... + wn = 1

7.2 portfolio ww 1 2 ww

2

1

2

2

2

2

2

σ =σ+σ+ρ 12 1, 21σσ 2

7.3 σ=∑ σ+∑∑ σσσ

=

portfolio wwaa^2 aaw

a

n

aaaa

a

n

a

n

22

=1

,

1 =1

12

2

2212

1

7.4 βp = w 1 β 1 + w 2 β 2 +...+ wnβn

where w 1 + w 2 + ... + wn = 1

7.5 E(ri) = rf + bi (E (rm) – rf)

KEY TERMS

actively managed, 251

beta, 232

capital asset pricing model

(CAPM), 245

correlation coefficient, 240

efficient markets hypothesis

(EMH), 250

expected return, 226

index fund, 251

market portfolio, 243

market risk premium, 244

passively managed, 251

portfolio weights, 237

selling short, 238

SELF-TEST PROBLEMS

Answers to Self-test problems and the Concept review questions throughout the chapter appear on

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