Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

Front Matter Preface © The McGraw−Hill^25

Companies, 2002

CONTENTS xxv

PART FIVE

Risk and Return 379

Chapter 12
Some Lessons from Capital Market History 381

12.1 Returns 382
Dollar Returns 382
Percentage Returns 384
12.2 The Historical Record 386
A First Look 387
A Closer Look 387
12.3 Average Returns: The First Lesson 392
Calculating Average Returns 392
Average Returns: The Historical Record 392
Risk Premiums 394
The First Lesson 395
12.4 The Variability of Returns: The Second
Lesson 396
Frequency Distributions and Variability 396
The Historical Variance and Standard Deviation 396
The Historical Record 399
Normal Distribution 399
The Second Lesson 402
Using Capital Market History 402
12.5 Capital Market Efficiency 403
Price Behavior in an Efficient Market 403
The Efficient Markets Hypothesis 404
Some Common Misconceptions about
the EMH 405
The Forms of Market Efficiency 407
12.6 Summary and Conclusions 407

Chapter 13
Return, Risk, and the Security Market Line 415

13.1 Expected Returns and Variances 416
Expected Return 416
Calculating the Variance 418
13.2 Portfolios 420
Portfolio Weights 420
Portfolio Expected Returns 420
Portfolio Variance 422
13.3 Announcements, Surprises, and
Expected Returns 423
Expected and Unexpected Returns 423
Announcements and News 424
13.4 Risk: Systematic and Unsystematic 425
Systematic and Unsystematic Risk 425

Systematic and Unsystematic Components of

Return 426

13.5 Diversification and Portfolio Ris k427

The Effect of Diversification: Another Lesson from

Market History 427

The Principle of Diversification 428

Diversification and Unsystematic Risk 429

Diversification and Systematic Risk 429

13.6 Systematic Risk and Beta 430

The Systematic Risk Principle 430

Measuring Systematic Risk 431

Portfolio Betas 432

13.7 The Security Market Line 433

Beta and the Risk Premium 434

The Reward-to-Risk Ratio 435

The Basic Argument 435

The Fundamental Result 437

The Security Market Line 439

Market Portfolios 439

The Capital Asset Pricing Model 439

13.8 The SML and the Cost of Capital: A Preview 442

The Basic Idea 442

The Cost of Capital 442

13.9 Summary and Conclusions 443

Chapter 14

Options and Corporate Finance 453

14.1 Options: The Basics 454

Puts and Calls 454

Stock Option Quotations 454

Option Payoffs 456

14.2 Fundamentals of Option Valuation 459

Value of a Call Option at Expiration 459

The Upper and Lower Bounds on a Call Option’s

Value 459

The Upper Bound 460

The Lower Bound 460

A Simple Model: Part I 461

The Basic Approach 462

A More Complicated Case 462

Four Factors Determining Option Values 463

14.3 Valuing a Call Option 464

A Simple Model: Part II 464

The Fifth Facto r465

A Closer Look 466

14.4 Employee Stock Options 467

ESO Features 467

ESO Repricing 468

14.5 Equity as a Call Option on the Firm’s Assets 468