Chapter 11

Fundamentals of Corporate Finance

Fourth Edition

Risk, Return, and Capital Budgeting

Slides by Matthew Will

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Topics Covered
Measuring Market Risk Portfolio Betas Risk and Return CAPM and Expected Return Security Market Line Capital Budgeting and Project Risk

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Measuring Market Risk

Market Portfolio - Portfolio of all assets in the economy. In practice a broad stock market index, such as the S&P Composite, is used to represent the market. Beta - Sensitivity of a stocks return to the return on the market portfolio.

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Measuring Market Risk

Example - Turbo Charged Seafood has the following % returns on its stock, relative to the listed changes in the % return on the market portfolio. The beta of Turbo Charged Seafood can be derived from this information.

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Measuring Market Risk

Example - continued
Month Market Return % Turbo Return % 1 2 3 4 5 6
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+ 1 + 1 + 1 -1 -1 -1

+ 0.8 + 1.8 - 0.2 - 1.8 + 0.2 - 0.8

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Measuring Market Risk

Example - continued When the market was up 1%, Turbo average % change was +0.8% When the market was down 1%, Turbo average % change was -0.8% The average change of 1.6 % (-0.8 to 0.8) divided by the 2% (-1.0 to 1.0) change in the market produces a beta of 0.8.

B =
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1.6 2

= 0.8

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Measuring Market Risk

Example - continued
Turbo return % 1 0.8 0.6 0.4 0.2 0 -0.2-0.8 -0.6 -0.4 -0.2 -0.4 -0.6 -0.8
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Market Return %

0.2

0.4

0.6

0.8

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Portfolio Betas
Diversification decreases variability from unique risk, but not from market risk. The beta of your portfolio will be an average of the betas of the securities in the portfolio. If you owned all of the S&P Composite Index stocks, you would have an average beta of 1.0
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Stock Betas
Stock Amazon DellComputer GE Ford Delta Airlines PepsiCo McDonald's Pfizer ExxonMobil H.J.Heinz
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Beta 3.30 2.14 1.18 1.05 1.00 .67 .66 .57 .41 .31

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Risk and Return

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Risk and Return

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Measuring Market Risk

Market Risk Premium - Risk premium of market portfolio. Difference between market return and return on risk-free Treasury bills.
14 12
Expected Return (%) .

10 8 6 4 2 0 0 0.2 0.4 Beta 0.6 0.8

Market Portfolio

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Measuring Market Risk

CAPM - Theory of the relationship between risk and return which states that the expected risk premium on any security equals its beta times the market risk premium.

Market risk premium = rm - rf Risk premium on any asset = r - rf Expected Return = rf + B(rm - rf )

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Measuring Market Risk

Security Market Line - The graphic representation of the CAPM.

Expected Return (%) .

Security Market Line Rm

Rf

Beta
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1.0

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Capital Budgeting & Project Risk

The project cost of capital depends on the use to which the capital is being put. Therefore, it depends on the risk of the project and not the risk of the company.

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Capital Budgeting & Project Risk

Example - Based on the CAPM, ABC Company has a cost of capital of 17%. (4 + 1.3(10)). A breakdown of the companys investment projects is listed below. When evaluating a new dog food production investment, which cost of capital should be used?

1/3 Nuclear Parts Mfr.. B=2.0 1/3 Computer Hard Drive Mfr.. B=1.3 1/3 Dog Food Production B=0.6
AVG. B of assets = 1.3
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Capital Budgeting & Project Risk

Example - Based on the CAPM, ABC Company has a cost of capital of 17%. (4 + 1.3(10)). A breakdown of the companys investment projects is listed below. When evaluating a new dog food production investment, which cost of capital should be used? R = 4 + 0.6 (14 - 4 ) = 10% 10% reflects the opportunity cost of capital on an investment given the unique risk of the project.

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Web Resources
Click to access web sites Internet connection required

http://finance.yahoo.com www.duke.edu/~charvey

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