This document contains all the crucial information described in Chapter 6 of the Corporate Finance: A focused approach book. These notes contain all the information to prepare yourself for the exam with the information of this chapter.
Investors must have known these stocks were risky, with a chance of a gain or a loss. But given
the information available to them, they certainly invested with the expectation of a gain.
These examples show that what you expect to happen and what actually happens are often very
different—the world is risky!
The intrinsic value of a company is the present value of its expected future free cash flows
(FCFs) discounted at the weighted average cost of capital (WACC).
In this chapter, we start from the basic premise that investors like returns and dislike risk; this is
called risk aversion .
Therefore, people will invest in relatively risky assets only if they expect to receive relatively
high returns: the higher the perceived risk, the higher the expected rate of return an investor will
demand.
The concept of return provides inve1stors with a convenient way to express the financial
performance of an investment. To illustrate, suppose you buy 10 shares of a stock for $1,000.
The stock pays no dividends, but at the end of 1 year, you sell the stock for $1,100. What is the
return on your $1,000 investment?
Although expressing returns in dollars is easy, two problems arise:
• (1)
To make a meaningful judgment about the return, you need to know the
scale (size) of the investment; a $100 return on a $100 investment is a great
return (assuming the investment is held for 1 year), but a $100 return on a
$10,000 investment would be a poor return.
• (2)
You also need to know the timing of the return; a $100 return on a $100
investment is a great return if it occurs after 1 year, but the same dollar
return after 100 years is not very good.
, The solution to these scale and timing problems is to express investment results
as rates of return, or percentage returns. For example, the rate of return on the 1-
year stock investment, when $1,100 is received after 1 year, is 10%:
The rate of return calculation “standardizes” the dollar return by considering the
annual return per unit of investment.
risk refers to the chance that some unfavorable event will occur. For an
investment in financial assets or in new projects, the unfavorable event is ending
up with a lower return than you expected.
risk can be analyzed in two ways:
• (1)
on a stand-alone basis, where the asset is considered in isolation; and
• (2)
as part of a portfolio, which is a collection of assets.
Thus, an asset’s stand-alone risk is the risk an investor would face if she held
only this one asset.
An event’s probability is defined as the chance that the event will occur.
If all possible events, or outcomes, are listed, and if a probability is assigned to
each event, then the listing is called a discrete probability distribution. (Keep in
mind that the probabilities must sum to 1.0, or 100%.)
Suppose an investor is facing a situation similar to the debt ceiling crisis and
believes there are three possible outcomes for the market as a whole:
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