McGraw-Hill/Irwin

Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Risk, Return and the Capital Budget

This chapter introduces the quantitative techniques used to estimate the required returns on equity.

It also establishes the relationship between market risk and the relative riskiness of the firm.

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Measuring Market Risk

Market Portfolio - Portfolio of all assets in the
economy.

Beta - Sensitivity of a stocks return to the return on

the market portfolio.

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Measuring Beta: Example

Example The Fosterhouse Gourmet Foods corporation has the following % returns on its stock, relative to the listed changes in the % return on the market portfolio. Its beta () can be derived from this information.

Month * Market Return % Fosterhouse Return % 1 +1 +1.8 2 -1 +1.6 3 4 5 6 +1 +1 -1 -1 +0.2 -0.8 +0.0 -2.8
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* The returns are expressed as percentages, though the results will be identical if expressed as decimals.

Measuring Beta: Example (ctd)

When the market was up 1%, Fosterhouse Corporations average percent change was +.4%.
When the market was down 1%, Fosterhouse Corporations average percent change was -.4%. The change of .8% (-.4% to .4%) divided by the 2% (-1.0% to 1.0%) change in the market produces a beta of .4.

.4% ( .4%) .8% .4 1% (1%) 2%

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Measuring Beta Graphically

Fosterhouse Corporation Returns (%)

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Stock Betas for Common Stocks

(May 2005 - April 2010)

What factors contribute to the variation in these betas?

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Total Risk and Market Risk

Recall that total risk is a combination of unique risk and market risk.

What are the effects of diversification on unique risk and market risk?

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Portfolio Beta
The beta of your portfolio will be an average of the betas of the securities in the portfolio.

What would be the average beta if you owned all of the S&P Composite Index stocks?

What is the beta of the risk-free return, U.S. Treasury Bills?

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Portfolio Beta: Example

Example Calculate the beta of a portfolio that consists of 25% Ford, 25% Boeing, and 50% McDonalds.
Company Beta Weight BetaWeight Ford 2.53 .25 .63 Boeing 1.28 .25 .32 McDonald's .62 .50 .31
Portfolio Beta = 1.26

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Measuring Market Risk: The Market Risk Premium

Market Risk Premium - Risk premium of market portfolio; the difference between the market return and the return on risk-free Treasury bills.

Let, rf Risk-free rate of return rm Market Return Market Risk Premium = rm rf

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Market Risk Premium: Example

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Example:
market risk premium 8%
Market Portfolio (market return = 12%)

Let, rf 4% rm 12% Market Risk Premium = 8%

Expected Return (%)

10 8 6 4 2 0 0

rf 4%
0.2 0.4 Beta 0.6 0.8 1

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Capital Asset Pricing Model (CAPM)

Let r = expected return on any asset
Market risk premium rm - rf Risk premium on any asset r - rf r rf (rm rf ) or,* r rf (rm rf )

* Note: These are identical, the risk-free rate has just been moved to the right hand side.
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CAPM: Example
Let: rf 4% rm 12% Thus, the Market Risk Premium = 8%

Suppose 1.2

According to CAPM, the expected return on the asset is r rf (rm rf ) 4% 1.2 (8%) 13.6%

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Graphic Representation of CAPM

Security Market Line - The relationship between expected return and beta.

rm
rf

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CAPM Tested
Beta vs. Average Risk Premium

What do these results imply?

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Alternative Explanations to CAPM

Small minus big

High minus low book-to-market

http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html

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Alternative Explanations Tested

http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html

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CAPM and Expected Returns

Is CAPM useful?
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Project Risk and the Security Market Line

Company Cost of Capital: Expected rate of return demanded by investors in a company, determined by the average risk of the companys securities Project Cost of Capital: Minimum acceptable expected rate of return on a project given its risk. Which should be used to assess the value of a proposed project?

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Determinants of Project Risk

Consider:
1. Operating Leverage and Project Risk

2. The presence of non-diversifiable risk

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Project Risk and the Security Market Line

Should this project be accepted? Why? What does this imply, if anything, about this projects NPV?
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