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Chapter 11Fundamentals of

Corporate Finance

Fourth Edition

Risk, Return, andCapital Budgeting

Slides by

Matthew Will

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Topics Covered

Measuring Market Risk

Portfolio Betas

Risk and ReturnCAPM 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 TurboCharged Seafood can be derived from this

information.

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Measuring Market Risk

Month Market Return % Turbo Return %

1 + 1 + 0.82 + 1 + 1.8

3 + 1 - 0.2

4 - 1 - 1.8

5 - 1 + 0.2

6 - 1 - 0.8

Example - continued

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Measuring Market Risk

B = = 0.81.62

When the market was up 1%, Turboaverage % change was +0.8%

When the market was down 1%, Turboaverage % 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

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Measuring Market Risk

Example - continued

-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 %

Turbo

return %

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Portfolio Betas

Diversification decreases variability fromunique risk, but not from market risk.

The beta of your portfolio will be an

average of the betas of the securities in theportfolio.

If you owned all of the S&P CompositeIndex stocks, you would have an averagebeta of 1.0

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Stock Betas

.31Heinz.H.J

.41ExxonMobil

.57Pfizer

.66sMcDonald'

.67PepsiCo

1.00AirlinesDelta

1.05Ford

1.18GE

2.14erDellComput

3.30AmazonBetaStock

B

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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.

0

2

4

6

8

10

12

14

0 0.2 0.4 0.6 0.8 1

Beta

Expected

Return(%). 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 = r - r

Risk premium on any asset = r - r

Expected Return = r + B(r - r )

m f

f

f m f

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Measuring Market Risk

Security Market Line - The graphic representation

of the CAPM.

Beta

ExpectedReturn(%).

Rf

Rm

Security Market Line

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 costof capital of 17%. (4 + 1.3(10)). A breakdown of thecompanys investment projects is listed below. Whenevaluating a new dog food production investment, whichcost 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 aninvestment given the unique risk of the project.

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Web Resources

http://finance.yahoo.com

www.duke.edu/~charvey

Click to access web sites

Internet connection required

http://finance.yahoo.com/http://www.duke.edu/~charveyhttp://www.anelda.com/http://www.duke.edu/~charveyhttp://finance.yahoo.com/