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Chapter 8: Analysis of Risk andReturn

Risk-Return Relationship

Required Rate of Return= Risk-free return + Risk Premium

What Makes Up the Risk-Free Rate?

Risk-free Rate (rf)= Real Rate of Return + Expected Inflation

Real Rate of Return

The Time Value of Money Component

Return with no default riskAnd no expected inflation

Historically has averaged 2 4 percent

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Risk Premium

Compensation for separate elements of risk

Default risk premium

Seniority risk premium

Marketability (or liquidity) risk premium

Maturity risk premium

Default Risk Premium

Due to likelihood that the firm will default onpromised cash flow obligations, such as interestand principal

Default SpreadCorporate Bond Yield Treasure Yield

for same maturity

Higher likelihood of default higher premium

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Seniority Risk Premium

Due to different priority of claims in the event of

default

Higher priority lower premium

Marketability Risk Premium

Refers to the market liquidity of the security

Liquidity: The ability to quickly sell without asignificant loss of value

Higher liquidity lower premium

Maturity Risk Premium

Compensation for investing in longer-termsecurities

Indicated by the Yield Curve

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The Yield Curve

Shows the relationship between yields and terms

to maturity for securities that differ only in maturity

See The Living Yield Curve link in Webct

Shape can beupward slopingdownward sloping

flathumped

Normal yield curve is upward sloping

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Theories of the Yield Curve

1. Expectations Theory

Long-term interest rates are a function of:Short-term interest rates andExpected future short-term rates

Upward sloping curve: Future short-term rates areexpected to rise

Downward sloping curve: Future short-term ratesare expected to fall

2. Liquidity Preference Theory

Lenders prefer to invest short-term because long-term securities have higher interest rate risk

When interest rates change, short-term securityprices exhibit smaller prices changes thanlong-term securities

Short-term securities can be converted to cashwith less potential for loss in value

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3. Market Segmentation Theory

Securities markets are segmented by maturity

Markets differ for:Short-term securitiesIntermediate-term securitiesLong-term securities

Supply and demand conditions in each marketdetermine the yields in the market for each

maturity

Business and Financial Risk

Explain the variability, or risk, in firm earnings

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Business risk

Refers to the variability of firms operating income

(EBIT)

Due to use of assets with fixed costs

Factors affecting business riskFluctuations in salesFluctuations in operating costs

Product diversificationTechnologyMarket power

Financial Risk

Refers to variability in earnings per share (EPS)

Represents the additional risk arising from thefirms capital structure, or financing, decision

Due to the use of securities with fixed costs:Preferred stockBonds

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Chapter 8 8