Chapter 11

Fundamentals of
Corporate Risk, Return and
Finance Capital Budgeting
Fifth Edition

Slides by
Matthew Will

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11- 2

Topics Covered

Measuring Market Risk

Beta

Risk and Return

CAPM

Capital Budgeting and Project Risk

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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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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 + 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.

1.6
B = 2 = 0.8
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Measuring Market Risk

Example - continued
Turbo
return %

1
0.8
0.6
0.4
Market Return %
0.2
0
-0.2-0.8 -0.6 -0.4 -0.2 0 0.2 0.4 0.6 0.8 1
-0.4
-0.6
-0.8

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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
Ford
GE
1.34
.97
B
McDonald' s .90
Boeing .76 Betas calculated with
Wal - Mart .51 price data from
Pfizer .46 January 2001 thru
ExxonMobil .41 December 2004
H.J.Heinz .30

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11- 10

Risk and Return

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11- 11

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
Market
Expected Return (%) .

10
8 Portfolio
6
4
2
0
0 0.2 0.4 0.6 0.8 1
Beta
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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

Security Market Line - The graphic representation
of the CAPM.

Security Market Line

Expected Return (%) .

Rm

Rf

Beta 1.0

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Security Market Line

Return

SML

rf
1.0 BETA

SML Equation = rf + B ( rm - rf )
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Capital Asset Pricing Model

R = rf + B ( r m - rf )

CAPM

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Testing the CAPM

Beta vs. Average Risk Premium
Avg Risk Premium
1931-2002

30
SML

20 Investors

10
Market
Portfolio
0
Portfolio Beta
1.0

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11- 18

Testing the CAPM

Return vs. Book-to-Market
Dollars
(log scale)100

High-minus low book-to-market

10
Small minus big

2004
1986

1996
1926

1936

1946

1956

1966

0.1 1976

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

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11- 19

Stock Expected Returns

Stock Beta
Amazon 20.4
DellComputer 14.5

E (r )
Ford 12.4
GE 9.8
McDonald' s 9.3
Boeing 8.3
Wal - Mart 6.6
Pfizer 6.2
ExxonMobil 5.9
H.J.Heinz 5.1

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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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