Title: Risk, Return, and Capital Budgeting

Speaker: Rebecca Stull

Created by: Gene Lai

online.wsu.edu

MODULE 9

RISK, RETURN, AND CAPITAL

BUDGETING

Revised by Gene Lai

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Risk, Return and the Capital

Budgeting

This module introduces the quantitative techniques

used to estimate the required returns on equity.

It also establishes the relationship between market

risk and the relative riskiness of the firm.

Outline

Measuring Market Risk

Portfolio Betas

Risk and Return

CAPM and Expected Return

Security Market Line

Capital Budgeting and Project Risk

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Measuring Market Risk

Market Portfolio - Portfolio of all assets (including

rare coins and houses) 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 stock’s return to the return on

the market portfolio.

Beta and Market Risk

Beta measures a stock’s market risk. It shows a stock’s volatility relative to the market.

Beta shows how risky a stock is if the stock is held in a well-diversified 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

When the market was up 1%, Turbo average % change was +0.8% ((.8+1.8-.2)/3)

When the market was down 1%, Turbo average % change was -0.8%

Thus, beta or market risk is 0.8.

Example - continued

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How are betas calculated

Run a regression of past returns on Stock i versus returns on the market.

Example rIBM = a + b r S&P + e

Where r = returns = (P1 – P0 +Div1)/P0

We need returns of IBM and S&P 500 for the last 60 months

The slope of the regression line is defined as the beta coefficient.

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Measuring Beta Graphically

Beta

If beta = 1.0, stock has average risk.

If beta > 1.0, stock is riskier than average.

If beta < 1.0, stock is less risky than average.

Most stocks have betas in the range of 0.5 to 1.5.

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Can a beta be negative?

Answer: Yes.

If correlation coefficient between the return of

that specific stock and that of the market or

S&P 500 is negative, then beta is negative.

In this case, the slope of the regression line

will be negative.

A negative beta is highly unlikely. The beta

of gold can be negative.

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Stock Betas for Common Stocks (May 2005 - April 2010)

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Portfolio Beta

The beta of your portfolio will be a weighted average of the betas of the securities in the portfolio.

What would be the average beta if you owned all of the S&P Composite Index stocks?

One.

What is the beta of the risk-free return, U.S. Treasury Bills?

Zero.

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Portfolio Beta: Example

Example – Calculate the beta of a portfolio that consists of 25%

Ford, 25% Boeing, and 50% McDonald’s.

Company Beta Weight Beta×Weight

Ford 2.53 .25 .63

Boeing 1.28 .25 .32

McDonald's .62 .50 .31

Portfolio Beta = 1.26

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Measuring Market Risk:

The Market Risk Premium Market Risk Premium - Risk premium of market portfolio; the

difference between the market return and the return on risk-free Treasury

bills.

Let,

Risk-free rate of return

Market Return

Market Risk Premium =

f

m

m f

r

r

r r

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Market Risk Premium: Example

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 (

%) Let,

4%

12%

Market Risk Premium = 8%

f

m

r

r

Example:

4%fr

8%market risk premium

Market Portfolio

(market return = 12%)

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Capital Asset Pricing Model

(CAPM)

Market risk premium -

Risk premium on any asset -

( )

or,*

( )

m f

f

f m f

f m f

r r

r r

r r r r

r r r r

Let r = expected return on any asset

* Note: These are identical, the risk-free rate

has just been moved to the right hand side.

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CAPM: Example

According to CAPM, the expected return on the asset is

( ) 4% 1.2 (8%) 13.6%f m fr r r r

Let:

4%

12%

Thus, the Market Risk Premium = 8%

f

m

r

r

Suppose 1.2

Suppose β= 1

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Graphic Representation of

CAPM

Security Market Line - The relationship between expected

return and beta.

fr

mr

How Well Does the CAPM Work?

Almost everyone agrees high risk and high expected return concept

Investors are concerned with the market risk that cannot be eliminated by diversification

A good rule of thumb

Hard to test because we do not know expected return

Other factors such as size or market/book value ratio explain return better

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Alternative Explanations to

CAPM • Small minus big: small stock performed better

than big stocks even we adjusted for beta.

• High minus low book-to-market: high book-to-

market value stocks outperformed low book-to-

market value stocks.

• High book-to-market value stocks are

value stocks

• Low book-to-market value stocks are

glamour stocks.

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CAPM and Expected Returns

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Project Risk and the

Security Market Line

Which should be used to assess the value of a proposed project?

• Company Cost of Capital: Expected rate of return demanded

by investors in a company, determined by the average risk of

the company’s securities

• Project Cost of Capital: Minimum acceptable expected rate

of return on a project given its risk.

Capital Budgeting & Project Risk

Example - Based on the CAPM, what is the cost of capital of ABC Co. 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? (Assume risk premium is 10% and risk free rate is 4%.)

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Capital Budgeting & Project Risk

Example - Based on the CAPM, what is the cost of capital of ABC Co. 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? (Assume risk premium is 10% and risk free rate is 4%.)

1/3 Nuclear Parts Mfr.. Beta = 2.0

1/3 Computer Hard Drive Mfr.. Beta = 1.3

1/3 Dog Food Production Beta = 0.6

Answer:

AVG. beta of assets = 1.3 = (2 + 1.3 + 0.6)/3

ABC Company has a cost of capital of 17% = (4 + 1.3(10)).

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Capital Budgeting & Project Risk

The expected return for the new dog food production investment is

r = 4 + 0.6 (14 - 4 ) = 10%

10% reflects the opportunity cost of capital on an investment given the risk of the project (Dog food).

We should use 10%, not 17%.

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Project Risk and the

Security Market Line

Should this project be accepted? Why? Yes. Because the project’s rate of return is

higher than the required rate of return.

What does this imply, if anything, about this project’s NPV? This implies the

project has a positive NPV.

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Determinants of Project Risk

Consider:

1. Operating Leverage and Project Risk: high operating

leverage means high fixed costs and tends to have high

betas.

2. The presence of non-diversifiable risk: earnings are

strongly dependent on the state of the economy, tend to

have high betas and high cost of capital.

Don’t Add Fudge Factors to

Discount Rates

Should you use higher discount rate if you

believe the project has high risk such as

liability lawsuit or political risk in certain

country?

No.

Adjust expected cash flows not RRR (r).

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