There is a trade-off between risk and return, with higher risk investments requiring higher returns. Diversification is key to reducing risk without lowering returns. The risk of an investment depends on the time horizon, and the past does not guarantee future performance. Option pricing models like Black-Scholes are used in corporate finance for real options analysis, risk management, capital structure decisions, and compensation plans involving stock options. Real options give the right but not obligation to make business decisions around expansion, contraction, abandonment, waiting, and switching.

1. CHAPTER 6
Risk, Return and Capital
Asset Pricing Model

2. Risk
a hazard; a peril; exposure to loss or injury
• Stand-alone basis, where the asset is considered in isolation
• Portfolio basis, where the asset is held as one of a number of assets in
a portfolio.

3. Returns
the efficiency or profitability of an investment
.
• Dollar terms:
Dollar return = (Amount to be received) −(Amount invested)
=$1100 − $1000
DR= $100
*If at the end of the year you sell the stock for only $900, your dollar return will be −$100.

4. Capital Asset Pricing Model (CAPM)
.
measuring the risk of an individual stock
CAPM is widely used throughout finance for pricing risky securities and generating
expected returns for assets given the risk of those assets and cost of capital

5. To
consider: size of the investment
timing of the return

6. Rate of
Return
For example, the rate of return on the 1-year stock
investment, when $1,100 is received after 1 year, is
10%:

7. Distribution
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 probability
distribution.
*Keep in mind that the probabilities must sum to 1.0, or 100%

8. Weighted average of outcomes
multiply each possible outcome x probability of occurrence and then sum these products
The weights = probabilities
weighted average = expected rate of return, ^r, called “r-hat.”

9. Expected Rate of Return

10. Stand-alone risk
The involvement of the single unit or asset of the company. The risks associated with these
individual entities separately, dealing one section at a time is formally known under the
perspective of standalone risk

11. Portfolio Context risk
Most financial assets are actually held as parts of portfolios.
• Banks,
• pension funds,
• insurance companies,
• mutual funds, and other financial institutions
This being the case, from an investor’s standpoint the fact that a particular stock goes up or down is not the key issue:
What’s important are the portfolio’s return and its risk. Logically, then, the risk and return of an individual security should be
analyzed in terms of how that security affects the risk and return of the portfolio in which it is held.

12. STAND-ALONE PORTFOLIO
DEFINTION
RISK MEASURES
DIVERSIFICATION
RISK
CONSIDERATION
An asset’s stand-alone risk is the risk an
investor would face if he or she held only this
one asset
Individual standard deviation, Individual
variance, Individual coefficient of variance
etc.
Stand-alone risk measures the undiversified
risk of an individual asset.
An asset stand-alone risk considers the total
of an asset.
A portfolio risk of an investment is
where the assets are held as one of a
number of assets in a portfolio.
Portfolio standard deviation, Portfolio
variance, Portfolio covariance etc.
A portfolio is constructed to diversify
the risk arise from different sources.
A portfolio of asset considers the
diversification risk only.

13. The part of a stock’s risk that can be eliminated
is called diversifiable risk, while the part that cannot
be eliminated is called market risk.

14. Diversifiable
Risk is caused by such random events as
• Lawsuits
• Strikes
• successful and unsuccessful marketing programs
• winning or losing a major contract

15. Market Risk
Stems from factors that systematically affect most
firms
• War
• Inflation
• Recessions
• high interest rates
Because most stocks are negatively affected by
these factors, market risk cannot be eliminated by
diversification. In Environment scanning, we call this
economic factors.

16. 1. There is a trade-off between risk and return. The average
investor likes higher returns but dislikes risk. It follows that
higher-risk investments need to offer investors higher
expected returns.
2. Diversification is crucial. By diversifying wisely, investors
can dramatically reduce risk without reducing their
expected returns. Don’t put all of your money in one or
two stocks, or in one or two industries.
3. Real returns are what matters. All investors should
understand the difference between nominal and real
returns.
4. The risk of an investment often depends on how long you
plan to hold the investment.
5. The past gives us insights into the risk and returns on
various investments, but there is no guarantee that the
future will repeat the past. Stocks that have performed
well in recent years might tumble, while stocks that have
struggled may rebound

17. CHAPTER 8
Financial Option and
Application in Corporate
Finance
(Continuation, end part)
By: Cherry Ann Flores

18. Black-Scholes
Option Pricing
Model
The Black-Scholes option
pricing model (OPM),
developed in 1973, helped
give rise to the rapid growth
in options trading. This
model, which has even been
programmed into some
handheld and Web-based
calculators, is widely used by
option traders.

19. Application of option pricing in
corporate finance
Option pricing is used in four major areas of corporate finance:
(1) real options analysis for project evaluation and strategic decisions
(2) risk management
(3) capital structure decisions
(4) compensation plans

20. Real
Options
• Real options are a right but not an obligation to
make a business decision. The concept of a real
option is crucial to the success of a business as the
ability to choose the right business opportunity
bears a significant effect on the
company’s profitability and growth.
Option to expand Option to abandon Option to wait Option to contract Option to switch
Futuren expansion option to cease a
project or an asset
to realize its salvage
value
deferring the
business decision to
the future
option to shut down
a project at some
point in the future
option to shut down
a project at some
point in the future if
the conditions are
unfavorable and
resume it when the
conditions are
favorable

21. Risk
Management
Risk-based pricing looks at factors associated with
the ability of the borrower to pay back the loan,
namely a consumer's credit score, adverse credit
history (if any), employment status, income, dent
level, assets, collateral, the presence of a co-signer,
and so on.

22. Capital
Structure
Decision
• Decisions regarding the mix of debt and equity used
to finance operations are quite important.
Combination of capital is called capital structure.
The firm may use only equity, or only debt, or a
combination of equity +debt, or a combination of
equity + debt + preference shares or may use other
similar combinations.

23. Compensation
Plans
• Many companies use stock options as a part of their
compensation plans. It is important for boards of
directors to understand the value of these options
before they grant them to employees. We discuss
compensation issues associated with stock options
in more detail in Chapter 13