BUSINESS AND FAITH INTEGRATION

Chapter 12 Learning Objectives

1. Measure and interpret the market risk, or beta, of a security.

2. Relate the market risk of a security to the rate of return that investors demand.

3. Calculate the opportunity cost of capital for a project.

Risk, Return, and Capital Budgeting

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.

Chapter 12 Outline

· Measuring Market Risk

· Beta

· Portfolio Beta

· CAPM

· Capital Budgeting and Project Risk

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. Also known as market risk.

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 (β) can be derived from this information.

* The returns are expressed as percentages, though the results will be identical if expressed as decimals.

Note: In practice, estimates based on just 6 months would be very unreliable. Most estimates of standard deviation and beta use something like 5 years of monthly data.

Measuring Beta: Example (ctd)

· When the market was up 1%, Fosterhouse Corporation’s average percent change was +.4%.

· When the market was down 1%, Fosterhouse Corporation’s 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.

Beta (β) - Sensitivity of a stock’s return to the return on the market portfolio. Also known as market risk.

Note: In practice, estimates based on just 6 months would be very unreliable. Most estimates of standard deviation and beta use something like 5 years of monthly data.

Measuring Beta Graphically

Fosterhouse Corporation Returns (%)

Steps to this graph:

1. Observe rates of return, usually monthly, for the stock and the market.

2. Plot the observations.

3. Fit a line showing the average return to the stock at different market returns.

Stock Betas for Common Stocks

(May 2005 - April 2010)

What factors contribute to the variation in these betas?

Note: These estimates of beta used 5 years of monthly data.

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?

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?

Portfolio Beta: Example

Example – Calculate the beta of a portfolio that consists of 25% Ford, 25% Boeing, and 50% McDonald’s.