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FINE 3010-01Financial Management

Instructor: Rogério MazaliLecture 13: 11/30/2011

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FINE 3010-01Instructor: Rogério Mazali

Fundamentals of Corporate FinanceSixth Edition

Richard A. Brealey Stewart C. MyersAlan J. MarcusMcGraw Hill/Irwin

Chapter 12:

Risk, Return, and Capital Budgeting

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AgendaMeasuring Market Risk

Measuring BetaBetas for Amazon.com and Wal-MartTotal Risk and Market RiskPortfolio Betas

Risk and ReturnWhy the CAPM Makes SenseThe Security Market LineHow Well Does the CAPM work?Using the CAPM to Estimate Expected Returns

Capital Budgeting and Project RiskCompany vs. Project RiskDeterminants of Project Risk

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Measuring Market RiskChapter 11: we have seen

Use Variance and Std. Dev. As measures of total risk of an asset

Risk can be reduced through diversificationTwo types of risk:

Unique Risk (Idiosyncratic Risk) Market Risk (Systematic Risk)

If investors are fully diversified, only market risk matters

Investors will only be compensated by incurring in extra market risk, not extra total risk

How to measure market risk?

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Measuring Market RiskDifferent stocks have different exposures to

market riskHow exposed a firm is to market risk?We need a measure on how the firm’s stocks

vary when compared to the market portfolio.Statisticians gave us:

CovarianceCorrelation Coefficient

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Measuring Market RiskBack to original question: how to measure market

risk?Market Betas (or Market βs): measures how

sensitive a security is to market movementsGenerally we estimate β by OLS with a linear

regression

Ri = αi + βi* Rm

Generally, using the last 5 years of returns Ri – Return on asset ‘i’ Rm – Return on the marker (ex S&P 500) αi & βi – Regression coefficients

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Measuring Market Risk

m

imi

m

mii RVAR

RRCOV

,

,

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Measuring Market RiskExample:

States of Probability Stock A Stock B Market Risk Freethe World

Depression 0.25 -0.2 0.05 -0.05 0.03

Recession 0.25 0.1 0.2 -0.03 0.03

Normal 0.25 0.3 -0.12 0.14 0.03

Boom 0.25 0.5 0.09 0.28 0.03

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Measuring Market Risk

Stock A Stock B Market Risk FreeStock A 6.69% -0.49% 3.24% 0.00%

Stock B 1.32% -0.47% 0.00%

Market 1.81% 0.00%

Risk Free 0.00%

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Measuring Market RiskStatistics Stock A Stock B Market Risk Free

Expected Returns 17.50% 5.50% 8.50% 3.00%

Variance 6.69% 1.32% 1.81% 0.00%

Standard Deviation 25.86% 11.50% 13.46% 0.00%

Beta 1.79 -0.26 1.00 0.00

BetaA = Cov(RA, RM) / Var(RM)

= 0.0324 / 0.0181

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Measuring Market Riskβ – tells us how sensitive a stock is to

market movementsβ > 1: amplify the overall movements of the market0 < β < 1: move in the same direction as the market, but

not as farβ = 0: no correlation with the market, asset has no

market riskβ < 0: asset is negatively correlated with the market,

works as insurance against market downfalls

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Measuring Market Risk

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Measuring Market RiskAmazon.com Wal-Mart

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Measuring Market BetaPortfolio betas:

The β of a portfolio equals the weighted average β of the component stocks

Example: You have invested 40% of your money in asset A whose beta is 1.5 and 60% in asset B whose beta is 0.5. What is the portfolio beta?

Portfolio beta = 0.4*1.5 + 0.6*0.5 = 0.9Market Portfolio beta:

1

,

m

m

m

mmm RVAR

RVAR

RVAR

RRCOV

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Risk and ReturnWe have seen that Unique risk can be eliminated

through diversificationInvestors who can diversify only car about

market riskWe can use betas to predict expected returnsStocks are future investments: have to be

compensated for patience: expected return > risk-free rate (T-Bill)

Also, investors have to be compensated for incurring market risk, in the same proportion as their stocks are affected by changes in the market

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Risk and Return

This is known as the Capital Asset Pricing Model (CAPM).Example:

Rf = 5%Historical average market risk premium is 8.5%β = 1.5, β = 1 , β = 0.5,β = 0 ,β = -1 ,

)()(

premiumrisk rate free-risk Return Expected

)( PremiumRisk

fmifi

fmifi

RRRRE

RRRR

%5.3%5.80.1%5)()(

%00.5%5.80.0%5)()(

%25.9%5.85.0%5)()(

%5.13%5.80.1%5)()(

%25.17%5.85.1%5)()(

fmifi

fmifi

fmifi

fmifi

fmifi

RRRRE

RRRRE

RRRRE

RRRRE

RRRRE

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Risk and ReturnSecurity Market Line (SML): Graphical

Representation of CAPM, shows risk-return trade-off

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Risk and ReturnHow well does CAPM do in practice?

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Risk and ReturnHow well does CAPM do in practice?

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Capital Budgeting and Project RiskCompany beta vs. project betaSuppose Dell Computers is consider a project in the

pharmaceutical area. Does Dell’s beta tell anything about this project’s market risk?

A: No.Which beta is preferable? Dell’s or Pfizer’s?A: Pfizer’s.Example: suppose our firm have a project whose IRR is 11%.

The project is assumed to be as risky as the market, the current T-Bill rate is 3%, and the market historical risk premium is 7%. Should the company go forward with the project?

A: Yes. If the project’s risk/return point lies above the SML, project should go ahead.

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Capital Budgeting and Project Risk