INTRODUCTION TO RISK, RETURN , AND THE OPPORTUNITY COST OF CAPITAL
WE HAVE MANAGED to go through seven chapters
without directly addressing the problem of risk, but now the jig is up. We can no longer be satisfied with vague statements like "The opportunity cost of capital depends on the risk of the project." We need to know how risk is defined, what the links are between risk and the opportunity cost of capital, and how the financial manager can cope with risk in practical situations. In this chapter we concentrate on the first of these issues and leave the other two to Chapters 9 and 10. We start by sum marizing more than
100 years of evidence on rates of return in capital markets. ...view middle of the document...
permission of Princet on University Press; wi1h updates provided by the authors.
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 Start o f year
study by Diinson, Marsh, and Staunton that measures the historical performance of three portfolios of U.S. securities:1
1. A p ortfolio of Treasury bills, that is, U.S. government debt securities
maturing in less than one year. 2. A portfolio of U.S. government bonds. 3. A por tfolio of U.S. common stocks. These investments offer different degrees of risk. Treasury bills are about as safe an investment as you can make. There is no risk of default, and their short maturity means that the prices of Treasury bills are relatively stable. In fact, an investor who wishes to lend money for, say, three months can achieve a perfectly certain payoff by purchasing a Treasury bill maturing in three months. However, the investor cannot lock in a real rate of return: There is still some uncertainty about inflation. By switching to long-term government bonds, the investor acquires an asset whose price fluctuates as interest rates vary. (Bond prices fall when interest rates rise and rise when interest rates fall. ) An investor who shifts from bonds to common stocks shares in all the ups and downs of the issuing companies. Figure 8.1 shows how your money would have grown if you had invested $1 at the start of 1900 and reinvested all dividend or interest income in each of the three portfolios.3 Figure 8.2 is identical except that it depicts the growth in the real value of the portfolio. We will focus here on nominal values.
1 See E. Dimson, P.R. Marsh, and M. Staunton, Triumph of the Optimists: 101 Years of Investment Returns (Princeton, NJ: Princeton University Press, 2002). 2 Treasury bills were not issued before 1919. Before that date the interest rate used is the commercial paper rate. 3 Portfolio values are plotted on a log scale. If they were not, the ending values for the common stock portfolio would run off the top of the page.
How an investment of $1 at the start of 1900 would have grown in real terms, assuming reinvestment of all dividend and interest payments. Compare this plot with Figure 8.1, and note how inflation has eroded the purchasing power of returns to investors.
Source: E. Dimson, P. R. Marsh, and M. Staunton, Triumph of the Optimists: 101 Year,s of Investment Returns (Princeton, NJ: Princeton University Press, 2002), @ 2002 Reprinted by permission of Princeton University Press; with updates provided by the authors.
$1,000 . - - - - - -- - -- - - - - - - - -----..----. $914
- Common stock - Bonds - Bills
Average rates of return on U.S. Treasury bills, government bonds, and common stocks, 1900-2006 (figures in % per year)
Source: E. Dimson, P. R....