Introduction to Corporate Finance

PART 2: VALUATION, RISK AND RETURN

7-1 EXPECTED RETURNS

Ultimately, people want to know what return they should expect from an investment. Investors and

corporate managers decide upon investments based on their best judgements about what the future will

hold. In finance, when we use the term expected return, we have in mind a ‘best-guess’ estimate of how an

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+10%

+8%

+6%

+4%

+2%

+0%

2%

4%

6%

8%

1.0

0.5

0.0

Millions

Change in value

1 October 2012 1 November 2012 1 December 2012 1 January 2013

Volume

Daily SPHB price

S&P 500 Index daily price

LEARNING OBJECTIVES

After studying this chapter, you will be able to:

illustrate three different approaches

for estimating an asset’s expected

return

calculate a portfolio’s expected return,

standard deviation and its beta

explain how the capital asset pricing

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

expected return

describe the concept of market efficiency

and its important lessons for investors.

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LO7.2

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LO7.4

In this chapter, we continue our study of the

relationship between risk and return. We will see

that a share’s beta, a measure of how much a share’s

return varies in response to variations in overall

market returns, is an important determinant of its

expected return. This is the central insight of the

capital asset pricing model (CAPM), one of the most

important ideas in modern finance. The scholars

who developed the model earned a Nobel Prize in

Economics in 1990 for their research. The CAPM is

useful not only for investors in financial markets but

also for managers who need to understand what

returns shareholders expect on the money they

contribute to corporate ventures.

expected return
A forecast of the return that
an asset will earn over some
future period of time

Source: ‘Crossing Wall Street’, CWS Market Review, 4 January 2013