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Chapter 11Fundamentals of
Corporate Finance
Fourth Edition
Risk, Return, andCapital Budgeting
Slides by
Matthew Will
Irwin/McGraw Hill Copyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved
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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
7/30/2019 2. Risk, Return & Capital Budgeting
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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 %
7/30/2019 2. Risk, Return & Capital Budgeting
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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
7/30/2019 2. Risk, Return & Capital Budgeting
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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/