NLTC Diversification and Opportunity Cost Questions

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Northwest Louisiana Technical College

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1) Please describe the meaning of diversification. How does diversification reduce risk for the investor?

2) What is the opportunity cost of capital? How can a company measure opportunity cost of capital for a project that is considered to have average risk?



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Chapter 11 Introduction to Risk, Return, and the Opportunity Cost of Capital Copyright © 2015 by The McGraw-Hill Companies, Inc. All rights reserved Topics Covered 11.1 11.2 11.3 11.4 11.5 Rates of Return: A Review A Century of Capital Market History Measuring Risk Risk & Diversification Thinking About Risk 11- 2 Rates of Return Percentage return = capital gain + dividend initial share price 2.82 + 0.40 Percentage return = 12.61 = .255 or 25.5% 11- 3 Rates of Return Dividend yield = dividend initial share price Capital gain yield = capital gain initial share price 11- 4 Rates of Return 0.40 Dividend yield = 12.61 = .032 or 3.2% 2.82 Capital gain yield = 12.61 = .224 or 22.4% 11- 5 Rates of Return Nominal vs. Real rate of return 1 + real rate of return = 1 + nominal 1 + inflation rate 1 + real ROR = 11 ++ .255 .015 = 1.236 Real ROR = 23.6% 11- 6 Market Indexes ▪ Market Index — Measure of the investment performance of the overall market ▪ Dow Jones Industrial Average (The Dow) — Index of the investment performance of a portfolio of 30 “blue-chip” stocks ▪ Standard & Poor’s Composite Index (S&P 500) — Index of the investment performance of a portfolio of 500 large stocks, also called the S&P 500 11- 7 The Value of a $1 Investment in 1900 100,000 $25,507 Equities Bonds Bills 10,000 Dollars 1,000 $253 100 $74 10 2010 2014 2000 1990 1980 1970 1960 1950 1940 1930 1920 1910 1900 1 Year Start Source: Ibbotson Associates 11- 8 Expected Return 11- 9 2010 2005 2000 1995 1990 1985 1980 1975 1970 1965 1960 1955 1950 1945 1940 1935 1930 1925 1920 1915 1910 1905 1900 Rate of return (%) Rates of Return Common Stocks (1900-2013) 80 60 40 20 0 -20 -40 -60 Year 11- 10 Expected Return Expected interest rate on normal risk = + market return Treasury bills premium (1981) 21.6% = 14 + 7.6 (2014) 7.7% = .1 + 7.6 11- 11 Expected Returns 1900-1926 1927-1955 1956-1983 1984-2013 Stocks 11.0% 11.6% 11.0% 12.4% Treasury bills 4.9% 1.0% 5.6% 4.0% 11- 12 Country Risk Premiums (%) Country risk premiums (1900-2013) 11- 13 Measuring Risk ▪ Variance – Average value of squared deviations from mean – A measure of volatility ▪ Standard Deviation – Square root of variance – Another measure of volatility 11- 14 Number of Years Histogram of Returns % Return 11- 15 Measuring Risk Coin toss game calculating variance and standard deviation Expected return = (.25 × .40) + (.5 × .10) + (.25 × −.20) = .10 of 10% 11- 16 Risk and Diversification 11- 17 Stock Market Volatility 1900-2013 11- 18 Standard Deviations 11- 19 Risk and Diversification Portfolio rate of fraction of portfolio in = × return first asset rate of return on first asset fraction of portfolio + × in second asset rate of return on second asset 11- 20 Asset versus Portfolio Risk Two Asset Example: Gold and Auto stocks 11- 21 Asset versus Portfolio Risk Two Asset Example — (continued) Assume 25% in Gold and 75% in Auto 11- 22 Asset versus Portfolio Risk Two Asset Example — (continued) Sensitivity analysis 11- 23 Asset versus Portfolio Risk Two Asset Example — (continued) Sensitivity analysis graph 11- 24 Risk and Diversification ▪ Diversification - Strategy designed to reduce risk by spreading the portfolio across many investments ▪ Specific Risk - Risk factors affecting only that firm, also called “diversifiable risk” ▪ Market Risk - Economy-wide sources of risk that affect the overall stock market, also called “systematic risk” 11- 25 Risk and Diversification 11- 26 Risk and Diversification 11- 27 Thinking about Risk ▪ Message 1 – Some risks look big and dangerous but really are diversifiable ▪ Message 2 – Market risks are macro risks ▪ Message 3 – Risk can be measured 11- 28
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Running head: DIVERSIFICATION

Diversification and opportunity cost
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DIVERSIFICATION

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1) Please describe the meaning of diversification. How does diversification reduce the
risk for the investor?
Diversification is a method of sharing capital or portfolio to a variety of investments. The
primary objective of diversification is to reduce portfolio volatility by balancing the losses
of one class of assets by the profits from another type of asset (Boyes, 2014). For instance,
investing in shares alone makes individuals vulnerable to the consequences of risk since
their investments will rely on the performance of just one specific type of asset.
Diversification involves developing a balanced investment portfolio that inclu...


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