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McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved
Fundamentals of Corporate
Finance
Sixth Edition
Richard A. Brealey
Stewart C. Myers
Alan J. Marcus
Slides by
Matthew Will
Chapter 11
McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved
Risk, Return and Capital Budgeting
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Topics Covered
Measuring Market Risk Beta
Risk and Return CAPM
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 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
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
Example - continued
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Measuring Market Risk
B = = 0.81.62
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.
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 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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Stock Betas
BBetas calculated with price data from January 2003 thru December 2007
Stock BetaAmazon.com 2.39Ford 2.46Newmont Mining 0.84Intel 1.59Microsoft 1.04Dell Computer 1.27Boeing 1.23McDonalds 1.44Pfizer 0.67Dupont 1.24Disney 1.00ExxonMobil 0.81IBM 1.13Wal-Mart 0.24Campbell Suop 0.46GE 0.76Heinz 0.59
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Risk and Return
-10
-8
-6
-4
-2
0
2
4
6
8
10
-10 -8 -6 -4 -2 0 2 4 6 8 10
Market Return (%)
Van
guar
d E
xplo
rer
Ret
urn
(%)
Vanguard Explorer Fund 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
Exp
ecte
d R
etu
rn (
%)
. 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
Exp
ecte
d R
etu
rn (
%)
.
Rf
Rm
Security Market Line
1.0
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Testing the CAPM
Avg Risk Premium 1931-2005
Portfolio Beta1.0
SML30
20
10
0
Investors
Market Portfolio
Beta vs. Average Risk Premium
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Testing the CAPM
0.1
1
10
10019
26
1936
1946
1956
1966
1976
1986
1996
2006
High-minus low book-to-market
Return vs. Book-to-MarketDollars(log scale)
Small minus big
http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html
2007
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Stock Expected Returns
)(rE
Stock Expected returnAmazon.com 19.8Ford 20.2Newmont Mining 8.9Intel 14.1Microsoft 10.3Dell Computer 11.9Boeing 11.6McDonalds 13.1Pfizer 7.7Dupont 11.7Disney 10.0ExxonMobil 8.7IBM 10.9Wal-Mart 4.7Campbell Suop 6.2GE 8.3Heinz 7.1
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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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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
Capital Budgeting & Project Risk
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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