Fundamentals of Corporate Finance Chapter 11 Risk, Return and Capital Budgeting Fifth Edition Slides by Matthew Will McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 11- Topics Covered  Measuring Market Risk Beta  Risk and Return CAPM  Capital Budgeting and Project Risk McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 11- 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 McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 11- 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 McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 11- Measuring Market Risk Example - continued Month Market Return % Turbo Return % + + 0.8 + + 1.8 + - 0.2 -1 - 1.8 -1 + 0.2 -1 - 0.8 McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 11- Measuring Market Risk Example - continued  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 B = McGraw-Hill/Irwin 1.6 = 0.8 Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 11- Measuring Market Risk Example - continued McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 11- 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 McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 11- Stock Betas Stock Beta Amazon 2.49 DellComputer 1.64 McGraw-Hill/Irwin Ford 1.34 GE McDonald' s 97 90 Boeing 76 Wal - Mart Pfizer 51 46 ExxonMobil 41 H.J.Heinz 30 B Betas calculated with price data from January 2001 thru December 2004 Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 11- 10 Risk and Return McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 11- 11 Risk and Return McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 11- 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 McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 11- 13 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 + B(rm - rf ) McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 11- 14 Measuring Market Risk Expected Return (%) Security Market Line - The graphic representation of the CAPM Security Market Line Rm Rf Beta McGraw-Hill/Irwin 1.0 Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 11- 15 Security Market Line Return SML rf 1.0 BETA SML Equation = rf + B ( rm - rf ) McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 11- 16 Capital Asset Pricing Model R = rf + B ( r m - rf ) CAPM McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 11- 17 Testing the CAPM Beta vs Average Risk Premium Avg Risk Premium 1931-2002 30 20 SML Investors 10 Market Portfolio 1.0 McGraw-Hill/Irwin Portfolio Beta Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 11- 18 Testing the CAPM Dollars Return vs Book-to-Market (log scale) High-minus low book-to-market 2004 Small minus big http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 11- 19 Stock Expected Returns Stock Beta Amazon 20.4 DellComputer 14.5 McGraw-Hill/Irwin Ford 12.4 GE McDonald' s 9.8 9.3 Boeing 8.3 Wal - Mart Pfizer 6.6 6.2 ExxonMobil 5.9 H.J.Heinz 5.1 E (r ) Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 11- 20 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 McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 11- 21 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 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 McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights 11- 22 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 company’s investment projects is listed below When evaluating a new dog food production investment, which cost of capital should be used? R = + 0.6 (14 - ) = 10% 10% reflects the opportunity cost of capital on an investment given the unique risk of the project McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights [...]... on the risk of the project and not the risk of the company McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights 11- 21 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 company’s investment projects is listed below When evaluating a new dog food production investment, which cost of capital... Food Production B=0.6 AVG B of assets = 1.3 McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights 11- 22 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 company’s investment projects is listed below When evaluating a new dog food production investment, which cost of capital should be used?... Risk and Return McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights 11- 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 McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights 11- 13 Measuring Market Risk CAPM - Theory of the relationship... rf ) McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights 11- 14 Measuring Market Risk Expected Return (%) Security Market Line - The graphic representation of the CAPM Security Market Line Rm Rf Beta McGraw- Hill/Irwin 1.0 Copyright © 2007 by The McGraw- Hill Companies, Inc All rights 11- 15 Security Market Line Return SML rf 1.0 BETA SML Equation = rf + B ( rm - rf ) McGraw- Hill/Irwin... Copyright © 2007 by The McGraw- Hill Companies, Inc All rights 11- 16 Capital Asset Pricing Model R = rf + B ( r m - rf ) CAPM McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights 11- 17 Testing the CAPM Beta vs Average Risk Premium Avg Risk Premium 1931-2002 30 20 SML Investors 10 Market Portfolio 0 1.0 McGraw- Hill/Irwin Portfolio Beta Copyright © 2007 by The McGraw- Hill Companies,... http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights 11- 19 Stock Expected Returns Stock Beta Amazon 20.4 DellComputer 14.5 McGraw- Hill/Irwin Ford 12.4 GE McDonald' s 9.8 9.3 Boeing 8.3 Wal - Mart Pfizer 6.6 6.2 ExxonMobil 5.9 H.J.Heinz 5.1 E (r ) Copyright © 2007 by The McGraw- Hill Companies, Inc All rights 11- 20 Capital Budgeting & Project Risk  The project cost of. .. 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 McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights