chapter 11 fundamentals of corporate finance fifth edition slides by matthew will mcgraw-hill/irwin...

Chapter 11Fundamentals of

Corporate

Finance

Fifth Edition

Slides by

Matthew Will

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved

Risk, Return and Capital Budgeting

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved

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Topics Covered

Measuring Market RiskBeta

Risk and ReturnCAPM

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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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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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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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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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

.30Heinz.H.J

.41ExxonMobil

.46Pfizer

.51Mart-Wal

.76Boeing

.90sMcDonald'

.97GE

1.34Ford

1.64erDellComput

2.49Amazon

BetaStock

BBetas calculated with price data from January 2001 thru December 2004


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Risk and Return


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Risk and Return


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Measuring Market RiskMarket 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 RiskCAPM - 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 RiskSecurity 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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Security Market LineReturn

BETA

rf

1.0

SML

SML Equation = rf + B ( rm - rf )


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Capital Asset Pricing Model

R = rf + B ( rm - rf )

CAPM


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Testing the CAPM

Avg Risk Premium 1931-2002

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

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

200

4


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Stock Expected Returns

5.1Heinz.H.J

5.9ExxonMobil

6.2Pfizer

6.6Mart-Wal

8.3Boeing

9.3sMcDonald'

9.8GE

12.4Ford

14.5erDellComput

20.4Amazon

BetaStock

)(rE


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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


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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.


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Web Resources

http://finance.yahoo.com

http://moneycentral.msn.com

http://money.cnn.com

www.bloomberg.com

www.morningstar.com

www.duke.edu/~charvey

Click to access web sitesClick to access web sites

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chapter 11 fundamentals of corporate finance fifth edition slides by matthew will mcgraw-hill/irwin...

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