Fundamentals of corporate finance 5e mcgraw chapter 011

Fundamentals of
Corporate
Finance

Chapter 11

Risk, Return and
Capital Budgeting

Fifth Edition

Slides by
Matthew Will

McGraw-Hill/Irwin

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights


11- 2

Topics Covered
 Measuring Market Risk
Beta

 Risk and Return
CAPM

 Capital Budgeting and Project Risk

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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights


11- 3

Measuring Market Risk
Market Portfolio - Portfolio of all assets in the economy.
In practice a broad stock market index is used to
represent the market.
Beta - Sensitivity of a stock’s return to the return on the
market portfolio.

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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights


11- 4

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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11- 5

Measuring Market Risk
Example - continued
Month Market Return % Turbo Return %
1
+ 1
+ 0.8
2
+ 1
+ 1.8
3
+ 1
- 0.2
4
-1
- 1.8
5
-1
+ 0.2
6
-1
- 0.8
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11- 6

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 =
McGraw-Hill/Irwin

1.6
2

= 0.8

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11- 7

Measuring Market Risk
Example - continued

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11- 8

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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11- 9

Stock Betas
Stock

Beta

Amazon
2.49
DellComputer 1.64

McGraw-Hill/Irwin

Ford

1.34

GE
McDonald' s

.97
.90

Boeing

.76

Wal - Mart
Pfizer

.51
.46

ExxonMobil

.41

H.J.Heinz

.30

B
Betas calculated with
price data from
January 2001 thru
December 2004

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights


11- 10

Risk and Return

McGraw-Hill/Irwin

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights


11- 11

Risk and Return

McGraw-Hill/Irwin

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights


11- 12

Measuring Market Risk
Market Risk Premium - Risk premium of market
portfolio. Difference between market return
and return on risk-free Treasury bills.
Market
Portfolio

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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights


11- 13

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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11- 14

Measuring Market Risk

Expected Return (%) .

Security Market Line - The graphic
representation of the CAPM.

Security Market Line
Rm

Rf

Beta
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1.0

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11- 15

Security Market Line
Return
SML

rf
1.0

BETA

SML Equation = rf + B ( rm - rf )
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11- 16

Capital Asset Pricing Model
R = rf + B ( r m - rf )

CAPM
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11- 17

Testing the CAPM
Beta vs. Average Risk Premium
Avg Risk Premium
1931-2002

30

20

SML
Investors

10

Market
Portfolio

0

1.0
McGraw-Hill/Irwin

Portfolio Beta

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11- 18

Testing the CAPM
Dollars

Return vs. Book-to-Market

(log scale)

High-minus low book-to-market

2004

Small minus big

/>
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11- 19

Stock Expected Returns
Stock

Beta

Amazon
20.4
DellComputer 14.5

McGraw-Hill/Irwin

Ford

12.4

GE
McDonald' s

9.8
9.3

Boeing

8.3

Wal - Mart

Pfizer

6.6
6.2

ExxonMobil

5.9

H.J.Heinz

5.1

E (r )

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11- 20

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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11- 21

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
company’s 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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11- 22

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 company’s 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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