Managerial Finance

profileJdr
PPT_Chapter_12.pptx
Home>Business & Finance homework help>Management homework help>Managerial Finance

Copyright © 2015 by The McGraw-Hill Companies, Inc. All rights reserved

Chapter 12

Risk, Return, and Capital Budgeting

12- ‹#›

Topics Covered

12.1 Measuring Market Risk

12.2 What Can You Learn from Beta?

12.3 Risk and Return

12.4 The CAPM and the Opportunity Cost of Capital

12- ‹#›

2

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

12- ‹#›

3

Measuring Market Risk

Example

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

12- ‹#›

4

Measuring Market Risk

Example — (continued)

Month Market Return % Turbot 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

12- ‹#›

5

Measuring Market Risk

When the market was up 1%, Turbot average % change was +0.8%

When the market was down 1%, Turbot 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

Example — (continued)

12- ‹#›

7

Measuring Market Risk

Example — (continued)

12- ‹#›

8

-0.8 -0.8 -0.6 -0.4 -0.2 0 0.2 0.4 0.6 0.8 1 -0.64 -0.48 -0.32 -0.16 0 0.16 0.32 0.48 0.64 0.8 -0.8 -0.6 -0.4 -0.2 0 0.2 0.4 0.6 0.8 1 -0.8 -0.6 -0.4 -0.2 0 0.2 0.4 0.6 0.8 1 -0.8 -0.6 -0.4 -0.2 0 0.2 0.4 0.6 0.8 1

Market Return %

Turbot return %

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

12- ‹#›

9

Stock Betas

Betas calculated with price data from May 2008 thru April 2013

β

12- ‹#›

9

Stock Betas

β

12- ‹#›

9

Stock Betas

β

12- ‹#›

9

Portfolio Beta

12- ‹#›

Risk and Return

12- ‹#›

Risk and Return

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

12- ‹#›

11

East 0 0.2 0.4 0.6 0.8 1 4 4.87 5.74 6.61 7.48 8.35 9.2200000000000006 10.09 10.96 11.83 12.7

Beta

Expected Return (%)

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 + β(rm − rf)

12- ‹#›

13

Measuring Market Risk

Example

The return on the stock market is 10% and he risk free rate of return is 3%. What is the risk premium for a stock that has a beta of 0.5? What is the expected return of the stock?

Market risk premium = rm − rf = .10 − .03 = .07

Risk premium on any asset = r − rf = .5 × .07 = .035

Expected return = rf + β(rm − rf) = .03 + .035 = .065

12- ‹#›

13

Measuring Market Risk

Example – (continued)

Graph the stock as well as a stock with a beta of .2 and the market portfolio

12- ‹#›

15

Capital Asset Pricing Model

R = rf + β(rm − rf)

CAPM

12- ‹#›

Security Market Line

Return

Beta

rf

1.0

SML

SML equation = rf + β(rm − rf)

12- ‹#›

Stock Expected Returns

E(r)

12- ‹#›

9

Testing the CAPM

Avg Risk Premium 1931-2010

Portfolio Beta

1.0

SML

30

20

10

0

Investors

Market Portfolio

Beta vs. Average Risk Premium

12- ‹#›

Testing the CAPM

Return vs. Book-to-Market

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

12- ‹#›

High minus low book-to-market 1926 1927 1928 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 1940 1941 1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 1 0.97 1.003271 0.70439656909999993 0.67269872349049986 0.70115387949414798 0.74062884290966857 1.1410868582709264 1.4298959420992976 1.5535819410908869 1.8046407827711741 1.5615556693318968 1.757843216966916 1.8538214566133095 1.868652028266216 1.7877393954422889 1.88248958340073 2.4717088230051583 2.8884389305638281 3.6195028238895324 3.4682076058509499 3.2049706485668628 2.911395337158138 3.0135853134923885 3.0488442616602494 2.9037192748052214 2.7053952483360248 2.6905155744701768 2.6318623349467267 2.475003339783902 2.4631233237529391 2.3990821173353627 2.7517471885836611 2.9050195069877711 2.8405280739326426 2.8487656053470469 2.6060507757714788 2.4494271241476127 2.4102362901612508 2.925062761739694 3.0060870002398836 4.5265658049612165 5.6229000429228231 4.8255728168363667 4.2522947661962061 4.502329698448543 3.9751068907602187 3.0417517928097193 3.0177219536465225 3.4830546788988159 3.988445912807034 4.9133665199869849 5.6253133287330987 6.8235050677532492 7.2247271657371401 7.741295158087345 8.4620097373052765 9.6229974732635597 8.8483461766658422 8.8669277036368399 8.0077224091544306 7.1364822110384285 7.5425480488465144 6.6110433648139706 5.6828528763940893 6.5955190483429806 7.09414 02883977105 7.520498119730413 7.4167152456781329 6.8574949161540015 6.712801773423152 6.3999852107816331 4.7641489909058476 5.4682902117617314 5.3649395267594349 6.3746211456955599 6.5983703479094737 8.4274386083499806 8.8395403562982935 8.6486062846022502 8.6866601522545004 7.9726166877391798 8.2819542152234593 8.9950304731542001 10.211158593124647 9.5954257299592314 9.6482005714740069 Small minus big 1926 1927 1928 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 1940 1941 1942 1943 1944 1945 1946 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 1 0.9637 0.91406945000000006 1.02302652844 0.88491794710060001 0.74395051812747448 0.78516537683173648 0.90411793142174457 0.63857849496317809 0.72312628769630294 0.93427916370362341 0.89662771340636738 0.76867893870327875 0.63508253915664892 0.6290492550346608 0.70245930309720572 0.83648853812815249 1.1254116791976163 1.3301240636436626 1.5138141968328527 1.5446960064482429 1.6911331878595364 1.7416980701765366 1.6756877133168457 2.1321450464243545 2.0131713528338757 2.1063811864700841 1.9267068712641862 2.4110809787000025 2.5321172438307427 2.4908437327563018 2.3237081182883541 2.6248606904185245 2.6637086286367184 2.5233311839075636 2.6828057147305215 2.9328432073434061 3.4135362090269901 3.7688853283867001 4.076049482650216 4.0491475560647245 3.6997061219763387 4.3915511667859146 3.959861687090859 4.8330111890943934 4.2999300549372821 4.3850686700250403 5.1730655100285396 5.6960624330924245 6.2047208083675773 7.7236364622559615 8.3253077426657018 8.3885800815099625 8.2124198997982525 6.1461750530090118 7.6956257838725834 8.7637786426740991 10.552465863643882 12.599644241190793 12.716820932633869 13.922375557047559 13.755307050362989 15.756704226190802 15.120133375452694 13.656504464708874 11.759615994560811 14.610146911642351 17.388996854236726 17.239451481290288 17.525626375879707 18.149538674861027 20.450900178833407 18.667581683239135 12.361672590640955 17.457154032503155 20.634356066418729 22.71842602912702 23.815726006333854 26.118706711146338 28.508568375216225 32.636609075947533 28.707161343203452 28.977008659829568 27.336909969683216 26.445726704671543 24.705597887504155 26.622752283574474

Dollars, log scale

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

Company cost of capital

Opportunity cost of capital for investment in the firm as a whole

The company cost of capital is the appropriate discount rate for an average-risk investment project undertaken by the firm

12- ‹#›

16

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. β = 2.0

1/3 computer hard drive mfr. β = 1.3

1/3 dog food production β = 0.6

Average β of assets = 1.3

Capital Budgeting & Project Risk

12- ‹#›

19

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

Capital Budgeting & Project Risk

12- ‹#›

20