Finance Textbook Notes – Chapter 7: Bringing Together Risk and Expected Return


Notes from various chapters in the core finance textbook, Financial Management, Concepts and Applications by Ramesh K.S. Rao.
Subject: Finance
Source: Financial Management, Concepts and Applications by Ramesh K.S. Rao
  1. In finance, the value of an asset is the maximum that someone is willing to pay for it.
  2. For an asset to have value, it must provide some economic benefit, and procuring the assets must come at a cost. Costs can be either tangible (salary and wages) or intangible (prestige).
  3. The true cost of anything is the most valuable alternative given up or sacrificed. This cost is called and opportunity cost, and it is the relevant cost in financial decision making. This is not the same as the cost of an asset, which is a book value figure. The relevant costs in finance are opportunity costs and are calculated not by looking at historical costs and prices but by evaluating the available alternatives.
  4. Because opportunity cost is stated as a RRR (the return on the asset sacrificed), the notion of discounting figures into the value of an asset. The higher the RRR, the greater the discount (in present value terms) and therefore the lower the value. Therefore, asset values have an inverse relationship with opportunity cost.
  5. Accounting profit is defined as an increase in wealth, but not the creation of wealth. It occurs when income exceeds expense, or when the value of an investment increases. Economic profit is the excess profit that is gained from an investment over and above the profit that could be obtained from the best alternative forgone. This implies the creation of wealth.
  6. The personal valuation process is subjective and varies from person to person depending on their own personal views of the future and risk aversion. Personal value therefore lies in the eyes of the beholder, and RRR and risk premiums vary from investor to investor. The market valuation process is based on the workings of supply and demand in the market. It assumes that all investors estimate the risk of an asset and the risk premium in the same way, and that discount rates are determined by the marginal investor.
  7. If NPV=0 then no economic profit exists. Economic profit exists when NPV > 0.
  8. Shareholder wealth is created when economic profits arise. That is, when the value of in-use assets exceed their value in exchange. Financial managers try to engage in projects that yield a positive NPV (wealth created). By maximizing NPV, shareholder wealth is also maximized.
  9. The expected return as provided by CAPM is the risk-free rate + risk premium. This is the same equation used to express the RRR, or opportunity cost. Therefore the two equations are equal and the expected return implied by CAPM = RRR.
  10. An asset that plots above the SML is a positive NPV investment because it implies an economic profit.
  11. All assets will eventually plot on the SML because when an asset is overvalued (it lies below the SML), investors will recognize they are better off investing in a portfolio that earns the SML return than the particular asset. In doing so, investors will sell the asset and prices will fall until the value of the asset equates to a return that lies on the SML. In the long-run, markets are efficient and the potential for arbitrage is eliminated and an asset’s expected rate of return will equal the RRR.
  12. For financial managers the CAPM provides a framework for estimating the appropriate opportunity cost for evaluating an asset. The CAPM provides the market valuation theory that is required for calculating market values. Market theory provides an “average discount rate” that managers can use in an objective way and need not worry about the potentially different discount rates that the firm’s owners may have.
  13. In terms of reducing risk, hedging is useless because the only relevant risk in a project is its systematic risk. If stock prices are only affected by systematic risk, which is market risk that cannot be hedged, hedging becomes a futile exercise. However, hedging is not useless from the standpoint of altering the magnitude of expected cash flows. By increasing expected cash flows, rates of return can be increased while leaving risk (beta) unchanged.
  14. An efficient market is a capital market in which the market value of assets reflects all available information about the assets. In an efficient market, it is not possible to generate excessive returns consistently.
  15. Market efficiency is either:

    • Weak form efficient – stock prices reflect historical price performance – US at least
    • Semi-strong efficient – stock prices reflect all historical and publicly available information – US definitely
    • Strong form efficient – stock prices reflect both publicly available and private information – US not
  16. If markets are efficient, that implies:
    • That stock prices cannot be accurately predicted
    • There is no strategy that can be followed to consistently yield excess returns
    • All investments will in the long-run have an NPV=0
    • Managers must consistently pursue new positive NPV investments
    • An increase in a firm’s value does result in an increase in stock prices
    • The effectiveness of management decisions can be judged by the value of stock prices because US markets are semi-strong efficient
  17. It is not impossible to “make money” in an efficient market, but it is basically impossible to make money over an extended period of time. There are certainly one-off cases that seem to dispel this theory, but they are more anomalies than anything else.
  18. The theory of efficient markets has been tested extensively and the results generally support the theory. There is no strong evidence that over the long-run any individual or institution (other than corporate insiders) has been able to generate excess returns consistently.
  19. Because of the existence of noise traders, who trade not on information but on advice, for sentimental reasons, or whatever, prices may deviate from their fundamental values. As a result, asset prices may reflect more than just information about expected cash flows. This tends to weaken traditional notions of asset pricing.

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