One is tempted to say: 90% × Z + 10% × $0 = $1,100 A Z = $1,100 / 90% = $1,222, or a 22.2% return. But this is not correct. A promised return on $1,222 with a 10% chance of default is an expected return of 10%. If the investment has no systematic risk, the proper expected return is indeed 10%, or a return of 22.2% if the security does not default. If the investment does have systematic risk, the expected return must be greater than 10%, for a return in the no-default scenario higher than 22.2%.

We discuss these issues in later modules. For now, know that the expected return is after adjustment for expected defaults, and the expected return must be further adjusted for systematic risk.

The subsection "How capital markets reconcile preferences for current vs future consumption" on pages 19-21 is consistent with the discussions in Barro’s text on Macroeconomics and Landsburg’s text on Microeconomics. Brealey and Myers focus on the capital markets, whereas economists tend to focus on the individual actors. To avoid complexity, economists often assume that all consumers have the same preferences. This is not necessary; the capital markets construct a market preference based on the marginal consumer. Barro follows the same theory, but the explanation is better in the Brealey and Myers text.

Sections 2.4 and 2.5 on pages 23-25 are not tested on the final exam. They are worth reading, since they cover issues discussed in the Wall Street Journal and similar publications, but they are not needed for this course.

The Summary at the end of each chapter is a good review, particularly for the final exam. Read the Summary on page 25; the section on page 26 reviews section 2.4 and 2.5 of the text and is not tested on the final exam.

The quiz at the end of each chapter is useful for checking that you understand the material. Review questions 1-5 on pages 26-27. Of the practice questions, review question 4 on page 27. Look at question 4 of the challenge questions on page 30; this type of problem comes up frequently in later chapters, and the question gives you a preview of this course.

These textbook questions are not the illustrative test questions, practice problems, or homework assignments for this course, though they help you review the material. The illustrative test questions, practice problems, or homework assignments for this course are shown separately on the discussion forum and the emails.

Hi there,

I have a text book from school. It's Corporate Finance (Fourth Canadian Edition), with author Ross Westerfield and Jaffe Roberts.

I was wondering if I can use this text for the readings.

Thanks,

[NEAS: No; this is a different text that covers different material.]