Chapter 4: Capital budgeting – risk and

return

Aims of the chapter

In this chapter the concepts of market risk and beta will be
described and this will include how each can be measured. The
capital asset pricing model (CAPM for short) will be
introduced and, through the use of beta, applied to the concept of
risk and the measurement of market and investment risk. The
relationship of market risk and the risk of a share to the rate
of return that investors require will be explained. This
required return, or opportunity cost of capital, will be
described and calculated and its application in capital budgeting
and project risk derivation shown.

Learning objectives
By the end of this chapter and having completed the essential
reading and activities, you should be able to:
calculate and interpret the risk associated with macroeconomic
factors (market risk) for a share
compare the rate of return that investors demand and the market
risk of a share
calculate the opportunity cost of capital for a project and be
able to explain its relationship to the company cost of capital.

Essential reading
Brealey, R.A., S.C. Myers and A.J. Marcus Fundamentals of
Corporate Finance. (McGraw-Hill Inc, 2007) Chapter 11.

Further reading
Brealey, R.A., S.C. Myers and F. Allen Principles of Corporate
Finance. (McGraw-Hill, 2008) Chapters 8, 9 and 10.

Introduction
In Chapter 3 you were required to confront the basic relationship
between the cost of capital and risk, and how risk associated with a
particular project could be measured. In the final section of Chapter
3 you were required to understand why the diversification of shares
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reduces unique risk (firm-specific risk) and not market risk

(associated with macroeconomic events faced by all firms). As
unique risk can be diversified away by holding a large portfolio of
shares, investors will need to earn a higher rate of return to
persuade them to take on market risk.
As this chapter is a logical extension of the previous chapter
(Introduction to risk and return), it is important that you
concentrate on the concepts and techniques used to measure and
interpret the market risk of a security and then proceed to relate
the market risk of a share to the rate of return that investors
demand and finally, show how the opportunity cost of capital of a
project can be calculated. Before you start reading Chapter 11 in
BMM here is a word of advice. The first section to this chapter
introduces you to measuring market risk and the beta of shares
(which is mainly empirical in nature), and the second section of
this chapter extends your understanding of the basic risk and return
relationship by introducing the capital asset pricing model and the
security market line. At a glance, both these sections may seem to
be very technical and the language used by the authors may prove
to be difficult to understand at first but we recommend that you
persevere through the entire chapter and then revisit the earlier
sections for a fuller understanding. We thoroughly recommend that
you also follow-up this chapter in BMM by reading the
corresponding chapters in BMA.

Measuring market risk

By holding a portfolio of investments comprising shares in different
businesses, in different industries, it is possible to diversify away
quite a lot of the risk. However, part of the risk of share ownership
cannot be diversified away. This is because this part of the risk
relates to factors which affect all businesses and their returns. This
part of risk is known as market risk or systematic risk; it is
caused by macroeconomic factors like changes in interest rates,
changes in oil prices, etc.
Total risk of investing in a particular share involves:
Unsystematic risk (or project specific risk) which is
diversifiable by holding a large portfolio of shares.
Systematic risk (or market risk) which is risk borne by all
companies.
Risk premium is the difference between market return
and the return from the risk free asset.
The part of total risk which cannot be diversified away requires a
risk premium to compensate investors for bearing it. This risk
premium relates to the extent to which the particular share is
affected by the macroeconomic factors associated with systematic
risk.
Beta is a measure of movements of a shares return to
the return on the market portfolio.
As risk depends upon exposure to macroeconomic events, it can be
measured as the sensitivity of a share’s return to fluctuations in
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returns on the market portfolio – as a total market portfolio

consisting of all types of investments is difficult to establish, a
substitute such as the FT All Share Index is used as a proxy for the
market portfolio. This sensitivity is termed as the share’s beta (ß).

Measuring beta
As you will have already worked out, some shares will be less
affected than others by market fluctuations. Investment managers
generally refer to these as follows:
where shares are not very sensitive to market fluctuations and
therefore have a beta less than one – defensive shares –
and
where shares are sensitive to market changes and therefore have
a beta value greater than one – aggressive shares.
Obviously investors will want to hold a portfolio of aggressive shares
should they expect the market to rise in the near future and hold a
portfolio of defensive shares should they anticipate the market will
fall in the near future.

Procedure for measuring real ’companies’ betas (in the UK):

1. Follow the rates of return for a particular UK company, usually
monthly/weekly returns over a particular time period and also
track the returns for a proxy of the market index such as the FT
All Share Index over the same period.
2. Plot the observations (i.e. the company share returns on the y-
axis and the proxy for the market returns over the same period on
the x-axis).
3. Fit a line of best fit showing the average returns for the share at
different market returns.
4. Beta of the share will be the slope of the fitted line (usually
calculated in practice using a technique known as regression
analysis).

Activity 4.1
At this point you may find it useful to go through how BMM calculate the betas
for Turbot-Charged Seafood, Amazon.com and Exxon Mobil.

Portfolio betas
The diversification of shares decreases the variability from unique
risk but not from market risk. The beta of a portfolio of shares is
just an average of the betas of the individual shares in the portfolio,
weighted by the investment in each share.

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Worked example 4
Calculate the portfolio beta if you have invested 25% in ICI shares, 25% in British
Airways shares and 50% in British Petroleum shares; and their respective betas
are 1.2, 1.0 and 0.8

Solution to Worked example 4

The portfolio beta is calculated as follows:
(0.25 × 1.2) + (0.25 × 1.0) + (0.5 × 0.8)
= 0.3 + 0.25 + 0.4
= 0.95

Risk and return

The market risk premium can be defined as the difference
between the market return and the return on risk-free treasury bills;
usually a proxy is adopted for the market return such as the FTSE
100 all share index (in the UK) or the S & P 500 index (in the US)
and the return on the risk free asset is the interest payable on
treasury bills issued by the government. For example, if the return on
the risk-free asset is 4.0% and the return on the market portfolio is
13.0% then the risk premium is 13.0 − 4.0 = 9.0%.
You must remember that the risk-free treasury bills will have a zero
beta and the fully diversified market portfolio will have a beta of
one; therefore, if you are told that the return on treasury bills is 4%
and the return on the market portfolio is 13%, you should be able to
plot the expected return against the beta; as illustrated below.
The bold line represents the security market line which
shows the relationship between expected return and
beta.

Figure 4.1 Plot of expected return against beta

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From this figure, you will notice that given the expected return for
risk-free treasury bills (zero beta asset) and the expected return for
the market portfolio (unitary beta asset), you will be able to
calculate the expected return for any asset which has a beta
between zero and one.
For example, if you have a portfolio split evenly between risk-free
assets (which offer an interest rate of 4%) and the market portfolio
(which offers an expected return of 13%) the expected return for
the portfolio will be:
(0.5 × 13%) + (0.5 × 4%) = 8.5%
You can also calculate the expected return for this example more
formally by using the following formulae:
(i) Market risk premium
= (rm – rf) = 13% − 4% = 9%
(ii) Risk premium of an investment
= ß(rm – rf)
You multiply (i) by beta as beta measures risk relative to the
market on any asset.
(iii) Risk premium of an investment with beta of 0.5 and market
risk premium of 9%
= ß(rm − rf)
= 0.5 × 9%
= 4.5%
(iv) Total expected return (r)
= risk-free rate + risk premium of investment
= rf + ß(rm − rf)
= 8.5%

Capital asset pricing model

ri = rf + ß(rm – rf)
where:
ri is the required rate of return on a particular investment i
rf is the risk-free rate
ß is a measure of the extent to which investment i is affected by
macroeconomic factors
rm is the expected average return from investing in the market
portfolio of shares.
This formula is commonly used to calculate expected returns and
states the basic risk-return relationship called the Capital Asset
Pricing Model or CAPM. According to the CAPM, expected rates of
return for all securities and all portfolios lie on the security market
line as illustrated above.

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The basic idea behind the CAPM is that investors expect a reward for
waiting and taking on risk. The riskier the investment, the greater the
expected return. Therefore, if you invest in a risk-free asset, you just
receive the rate of interest, say 4%, whereas if you invest in risky
shares, you can expect to gain an extra return or risk premium, say
9% for the increased risk you take on by investing in shares. So if
you invest in something twice as risky as the market (i.e. ß =
2) then the risk premium is doubled.
CAPM is the theory of the relationship between risk and
return which states that the expected risk premium on
any share equals the share’s beta multiplied by the
market risk premium.
Remember, the CAPM is only a model of risk and return. However,
the CAPM does capture two simple but fundamental ideas useful to
investment managers. First, almost everyone agrees that investors
require some extra return for taking on risk. Secondly, investors are
principally concerned with the market risk (the risk which they
cannot diversify away).
To calculate the returns that investors are expecting from particular
shares, you require – the risk-free rate, the expected market risk
premium, and beta.
For example, if the interest on treasury bills is 4% and the market risk
premium is 10% and the beta for Company Z shares is 0.65 then the
expected return on Company Z shares will be:
Expected return = risk-free rate + (beta × market risk premium)
= 4% + (0.65 × 10%)
= 10.5%

Activity 4.2
Calculate the expected return for a share if the risk-free rate of return is 8% and
the market premium is 12% and the beta for the company share is 0.87. Then
discuss how the beta for a company may be calculated in practice.
 See VLE for solution

Project returns and the opportunity cost of capital

The opportunity cost of capital is the return that investors give
up by investing in the project rather than in securities of equivalent
risk.

Worked example 5
Company Y has forecasted the cash flows on a project and estimate that the
internally required rate of return on this project (internal rate of return) is 10%.
Risk-free treasury bills offer a return of 4% and the expected risk premium is 7%.
Calculate whether the project is feasible if
(a) the project is a sure thing (i.e. the beta is zero)

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(b) the beta for company Y is 0.4

(c) the beta for company Y is 0.9.

Solution to Worked example 5

To answer this question you need to calculate the opportunity cost of capital.
Since we have already established in an earlier chapter that NPV is the best
criterion for project selection we need to note in this question that the selected
hurdle rate (cost of capital) is the relevant rate for a particular risk level. Thus if
a company presently had assets with risk class ß of 0.40 – the required return – the
hurdle rate in the calculation below is 6.8%, but if faced with a new riskier area of
business with ß of 0.90 then the hurdle rate is 10.30%.
If the company has a zero beta then
r = 4% + (0 × 7%) = 4%
If the company has a beta of 0.4 then
r = 4% + (0.4 × 7%) = 6.8%
If the company has a beta of 0.9 then
r = 4% + (0.9 × 7%) = 10.3%
Company Y would only consider the project if the beta was either zero or 0.4. If
the beta is 0.9 then company Y should not take on the project as the project is
riskier than the internal rate of return required by the firm (i.e. 0.3% is more than
10%).
(i) The corporate cost of capital is based on a portfolio of assets with individual
beta’s ßc = ∑ßi
(ii) When we are analysing whether a project is feasible the selection of an
individual project beta (or individual area of business beta) will be preferred to the
company’s cost of capital as the latter will be a weighted average of all project
betas for the company (the average of the betas for all business areas).
In practice, the security market line is a good indicator for project acceptance. If the
return on the project lies above the security market line, then the return is higher than
investors can expect to get by investing in the capital market.

Activity 4.3
Should the company accept a project (for the worked example above) if the beta
for the project was (i) 7.5%, (ii) 4.7% or (iii) 8.9%?
 See VLE for solution

Capital budgeting and project risk

Long before the risk-return relationship was established financial
managers realised that, other things being equal, risky projects
were not as desirable as those which were considered to be safe
projects, and thus would require a higher rate of return. In this way
the company cost of capital equated to the expected rate of return

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demanded by investors, which was determined by the average risk

of the company’s assets and operations.
Since investors will require a higher rate of return from a high-risk
company than from a low-risk company, high-risk firms will have a
higher company or asset cost of capital and they will therefore set a
higher discount rate for their new investment opportunities.
The project cost of capital may differ from the company cost of
capital as it will depend upon the use to which the company’s
capital is put. Therefore, the project cost of capital will depend
upon the risk of the project and not upon the risk of the company’s
existing business.

; A reminder of your learning outcomes

By the end of this chapter and having completed the essential
reading and activities, you should be able to:
calculate and interpret the risk associated with macroeconomic
factors (market risk) for a share
compare the rate of return that investors demand and the market
risk of a share
calculate the opportunity cost of capital for a project and be
able to explain its relationship to the company cost of capital.

Practise questions
1. Discuss whether, according to the CAPM, the expected rate of
return of a share with a beta less than zero would be more or less
than the risk-free rate? Why would investors be willing to invest
in such a security?
2. Share A had a beta of 0.5 and investors expect it will provide a
return of 5 per cent. Share B has a beta of 1.5 and investors
expect it to give a return of 13 per cent. Use the CAPM to find
the market risk premium and the expected rate of return on the
market.
3. A firm is considering the following projects, and the expected
returns calculated by the way of IRR’s are as follows:
Project Beta Expected return
A 0.8 13%
B 0.5 12%
C 1.6 19%
D 1.2 18%
(a) The risk free rate is 4% and the market return is 16%. If the
firm has a current single cost of capital as 16%, which
projects have a higher cost of capital than the firm’s?
(b) Which projects should be accepted?
 See VLE for solutions

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Problems
Attempt the following problems in BMM:
Numbers 1, 8 and 11 (pp. 313–316).
Attempt the following problems in BMA:
Chapter 9, p.231, numbers 5 and 8
Chapter 10, pp.260–261, numbers 9, 10 and 13

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Notes

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