Fundamentals of Corporate Finance/3e,ch10

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright

10-1

Chapter Ten

Some Lessons from Capital Market History


10-2

10.1 Returns

10.2 Inflation and Returns

10.3 The Historical Record

10.4 Average Returns: The First Lesson

10.5 The Variability of Returns: The Second Lesson

10.6 Capital Market Efficiency

10.7 Summary and Conclusions

Chapter Organisation


10-3

Chapter Objectives

• Distinguish between dollar returns and percentage returns.• Examine the effect of inflation on returns.• Gain an appreciation of historical returns and their variability

for different assets.• Calculate average return and standard deviation.• Discuss market efficiency and its three forms.


10-4

Dollar Returns

• The gain (or loss) from an investment.

• Made up of two components:– income (e.g. dividends, interest payments)– capital gain (or loss).

• Not necessary to sell investment to include capital gain or loss in return.


10-5

Dividends paid at Change in market end of period value over periodPercentage return = Beginning market value

Dividends paid at Market value end of period at end of period1 + Percentage return = Beginning market value

+

+

Percentage Returns


10-6

Percentage Return Example

Pt = $37.00 Pt+1 = $40.33 Dt+1 = $1.85

14%or 0.14 $37.00

$37.00 $40.33 $1.85 Return %

Per dollar invested we get 5 cents in dividends and 9 cents in capital gains—a total of 14 cents or a return of 14 per cent.


10-7

Inflows

Outflows

$42.18

$1.85

$40.33

Total

Dividends

Endingmarket value

t = 1t

– $37

Time

Percentage Returns


10-8

Inflation and Returns

• Real return is the return after taking out the effects of inflation.

• Real return shows the percentage change in buying power.• Nominal return is the return before taking out the effects of

inflation.• The Fisher effect explores the relationship between real

returns (r), nominal returns (R) and inflation (h).

h r R 111

R ≈ r + h


10-9

Average Equivalent Returns & Risk Premiums 1978–2002


10-10

Average Returns: The First Lesson

Risky assets on average earn a risk premium (i.e. there is a reward for bearing risk).


10-11

Frequency of Returns on Ordinary Shares 1978–2002


10-12

Variance

• Measure of variability.

• The mean of the squared deviations from the average return.

2211

1Var R R .... R R

T R T


10-13

Example—Variance

ABC Co. have experienced the following returns in the last five years:

Calculate the average return and the standard deviation.

Year Returns

1998 -10%

1999 5%

2000 30%

2001 18%

2002 10%


10-14

Example—Variance


10-15

Example—Variance

14.89%or 0.1489 0.02218 deviation Std

0.02218 1 5

0.08872 Variance


10-16

The Historical Record

Conclusion: Historically, the riskier the asset, the greater the return.


10-17

The Normal Distribution


10-18

Variability: The Second Lesson

• The greater the risk, the greater the potential reward.

• This lesson holds over the long term but may not be valid for the short term.


10-19

Capital Market Efficiency

• The efficient market hypothesis (EMH) asserts that the price of a security accurately reflects all available information.

• Implies that all investments have a zero NPV.

• Implies also that all securities are fairly priced.

• If this is true then investors cannot earn ‘abnormal’ or ‘excess’ returns.


10-20

Price ($)

Days relativeto announcement day–8 –6 –4 –2 0 +2 +4 +6 +7

220

180

140

100

Overreaction andcorrection

Delayed reaction

Efficient market reaction

Price Behaviour in Efficient and Inefficient Markets


10-21

What Makes Markets Efficient?

• There are many investors out there doing research:

- As new information comes into the market, this information is analysed and trades are made based on this information.

- Therefore, prices should reflect all available public information.

• If investors stop researching stocks, then the market will not be efficient.


10-22

Common misconceptions about EMH

• Efficient markets do not mean that you can’t make money.

• They do mean that, on average, you will earn a return that is appropriate for the risk undertaken and that there is not a bias in prices that can be exploited to earn excess returns.

• Market efficiency will not protect you from making the wrong choices if you do not diversify—you still don’t want to put all your eggs in one basket


10-23

Price Behaviour in Efficient and Inefficient Markets

• Efficient market reaction: The price instantaneously adjusts to and fully reflects new information. There is no tendency for subsequent increases and decreases.

• Delayed reaction: The price partially adjusts to the new information. Several days elapse before the price completely reflects the new information.

• Overreaction: The price over-adjusts to the new information. It ‘overshoots’ the new price and subsequently corrects itself.


10-24

Forms of Market Efficiency

• Weak form efficiency: Current prices reflect information contained in the past series of prices.

• Semi-strong form efficiency: Current prices reflect all publicly available information.

• Strong form efficiency: Current prices reflect all information of every kind.

Business

Fundamentals of Corporate Finance/3e,ch10