Fundamentals of Corporate Finance/3e,ch11

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  • 1. Copyright  2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright11-1Chapter ElevenReturn, Risk and the SecurityMarket Line
  • 2. Copyright  2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright11-211.1 Expected Returns and Variances11.2 Portfolios11.3 Announcements, Surprises and Expected Returns11.4 Risk: Systematic and Non-systematic11.5 Diversification and Portfolio Risk11.6 Systematic Risk and Beta11.7 The Security Market Line11.8 The Capital Market Line11.9 Portfolio Characteristics11.10 The SML and the Cost of Capital: A PreviewChapter Organisation
  • 3. Copyright  2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright11-311.11 Problems with the CAPM11.12 Summary and ConclusionsChapter Organisation (continued)
  • 4. Copyright  2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright11-4Chapter Objectives• Calculate the expected return and risk (standard deviation) ofboth a single asset and a portfolio.• Distinguish between systematic and non-systematic risk.• Explain the principle of diversification.• Explain the capital asset pricing model (CAPM).• Distinguish between the security market line (SML) and thecapital market line (CML).
  • 5. Copyright  2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright11-5Expected Return and Variance• Expected return—the weighted average of the distribution ofpossible returns in the future.• Variance of returns—a measure of the dispersion of thedistribution of possible returns.• Rational investors like return and dislike risk.
  • 6. Copyright  2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright11-6Example—Calculating ExpectedReturnState ofEconomyPiProbabilityof State iRiReturn inState iBoom 0.25 35%Normal 0.50 15%Recession 0.25 –5%     15%5%0.2515%0.5035%0.25returnExpected
  • 7. Copyright  2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright11-7Example—Calculating VarianceState ofEconomy(Ri – R) (Ri – R)2Pi x (Ri – R)2Boom 0.20 0.04 0.01Normal 0 0 0Recession – 0.20 0.04 0.012= 0.0214.14%or0.14140.02
  • 8. Copyright  2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright11-8Example—Expected Return andVarianceState ofEconomyPi Return onAsset AReturn onAsset BBoom 0.40 30% –5%Bust 0.60 –10% 25%           13%0.130.250.600.050.406%0.060.100.600.300.40REREBAExpected Returns:
  • 9. Copyright  2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright11-9Example—Expected Return andVariance          0.02160.130.250.600.130.050.40Var0.03840.060.100.600.060.300.40Var2222BARR   14.7%0.1470.021619.6%0.1960.0384RσRσBAVariances:Standard deviations:
  • 10. Copyright  2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright11-10Portfolios• A portfolio is a collection of assets.• An asset’s risk and return is important in how itaffects the risk and return of the portfolio.• The risk–return trade-off for a portfolio is measuredby the portfolio’s expected return and standarddeviation, just as with individual assets.
  • 11. Copyright  2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright11-11Portfolio Expected Returns• The expected return of a portfolio is the weightedaverage of the expected returns for each asset inthe portfolio.mE(Rp) = ∑ wjE (Rj)j =1• You can also find the expected return by findingthe portfolio return in each possible state andcomputing the expected value as we did withindividual securities.
  • 12. Copyright  2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright11-12Example—Portfolio Return andVarianceState ofEconomyPi RA RB RBoom 0.40 30% –5% 12.Bust 0.60 –10% 25% 7.5Assume 50 per cent of portfolio in asset A and50 per cent in asset B.     9.5%or0.0950.0750.600.1250.40RE p
  • 13. Copyright  2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright11-13Example—Portfolio Return andVariance• Var(Rp)  (0.50 x Var(RA)) + (0.50 x Var(RB)).• By combining assets in a portfolio, the risks faced by theinvestor can significantly change.      2.45%or0.02450.00060.00060.0950.0750.600.0950.1250.40Var22ppRR
  • 14. Copyright  2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright11-14Asset A returns0.050.040.030.020.010-0.01-0.02-0.03-0.04-0.050.050.040.030.020.010-0.01-0.02-0.03Asset B returns0.040.030.020.010-0.01-0.02-0.03Portfolio returns:50% A and 50% BThe Effect of Diversification onPortfolio Variance
  • 15. Copyright  2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright11-15Announcements, Surprises andExpected Returns• Key Issues– What are the components of the total return?– What are the different types of risk?• Expected and Unexpected Returns– Total return (R) = expected return (E(R))+ unexpectedreturn (U)• Announcements and News– Announcement = expected part + surprise– It is the surprise component that affects a stock’s priceand, therefore, its return.
  • 16. Copyright  2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright11-16Risk• Systematic risk: that component of total risk which is due toeconomy-wide factors.• Non-systematic risk: that component of total risk which isunique to an asset or firm.   portionsystematic-nonportionsystematicreturnUnexpectedreturnExpectedreturnTotalREURER
  • 17. Copyright  2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright11-17Standard Deviations of MonthlyPortfolio ReturnsNumber ofSharesAverage StandardDeviationRatio of StandardDeviations1 11.49% 1.005 7.91% 0.6910 6.61% 0.5815 6.08% 0.5320 5.71% 0.5025 5.60% 0.4930 5.50% 0.4835 5.50% 0.4840 5.26% 0.4645 5.12% 0.45
  • 18. Copyright  2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright11-18Diversification• The process of spreading investments across differentassets, industries and countries to reduce risk.• Total risk = systematic risk + non-systematic risk• Non-systematic risk can be eliminated by diversification;systematic risk affects all assets and cannot be diversifiedaway.
  • 19. Copyright  2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright11-19The Principle of Diversification• Diversification can substantially reduce thevariability of returns without an equivalent reductionin expected returns.• This reduction in risk arises because worse thanexpected returns from one asset are offset bybetter than expected returns from another.• However, there is a minimum level of risk thatcannot be diversified away and that is thesystematic portion.
  • 20. Copyright  2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright11-20Portfolio Diversification
  • 21. Copyright  2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright11-21Systematic Risk• The systematic risk principle states that the expected returnon a risky asset depends only on the asset’s systematic risk.• The amount of systematic risk in an asset relative to anaverage risky asset is measured by the beta coefficient.Std Deviation BetaSecurity A 30% 0.60Security B 10% 1.20• Security A has greater total risk but less systematic risk (morenon-systematic risk) than Security B.
  • 22. Copyright  2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright11-22Measuring Systemic Risk• What does beta tell us?- A beta of 1 implies the asset has the samesystematic risk as the overall market.- A beta < 1 implies the asset has lesssystematic risk than the overall market.- A beta > 1 implies the asset has moresystematic risk than the overall market.
  • 23. Copyright  2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright11-23Beta Coefficients for SelectedCompaniesCompany Beta CoefficentAmcor 0.78BHP 1.33Boral 0.85Caltex Australia 1.38CSR 0.96Coles Myer 0.45Mayne Nickless 0.68NAB 1.27
  • 24. Copyright  2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright11-24Example—Portfolio Beta CalculationsAmount PortfolioShare Invested Weights Beta(1) (2) (3) (4) (3)  (4)ABC Company $6 000 50% 0.90 0.450LMN Company 4 000 33% 1.10 0.367XYZ Company 2 000 17% 1.30 0.217Portfolio $12 000 100% 1.034
  • 25. Copyright  2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright11-25Example—Portfolio ExpectedReturns and Betas• Assume you wish to hold a portfolio consisting of asset A anda riskless asset. Given the following information, calculateportfolio expected returns and portfolio betas, letting theproportion of funds invested in asset A range from 0 to 125per cent.• Asset A has a beta of 1.2 and an expected return of 18 percent.• The risk-free rate is 7 per cent.• Asset A weights: 0 per cent, 25 per cent, 50 per cent, 75 percent, 100 per cent and 125 per cent.
  • 26. Copyright  2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright11-26Example—Portfolio ExpectedReturns and BetasProportion Proportion PortfolioInvested in Invested in Expected PortfolioAsset A (%) Risk-free Asset (%) Return (%) Beta0 100 7.00 0.0025 75 9.75 0.3050 50 12.50 0.6075 25 15.25 0.90100 0 18.00 1.20125 –25 20.75 1.50
  • 27. Copyright  2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright11-27Return, Risk and Equilibrium• Key issues:– What is the relationship between risk and return?– What does security market equilibrium look like?• The ratio of the risk premium to beta is the same for everyasset. In other words, the reward-to-risk ratio for the marketis constant and equal to: ifi RREratiokReward/ris
  • 28. Copyright  2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright11-28Example—Asset Pricing• Asset A has an expected return of 12 per cent and a beta of1.40. Asset B has an expected return of 8 per cent and abeta of 0.80. Are these two assets valued correctly relative toeach other if the risk-free rate is 5 per cent?• Asset B offers insufficient return for its level of risk, relative toA. B’s price is too high; therefore, it is overvalued (or A isundervalued).0.03750.800.050.08:B0.051.400.050.12:A
  • 29. Copyright  2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright11-29Security Market Line• The security market line (SML) is therepresentation of market equilibrium.• The slope of the SML is the reward-to-risk ratio:(E(RM) – Rf)/ßM• But since the beta for the market is ALWAYS equalto one, the slope can be rewritten.• Slope = E(RM) – Rf = market risk premium
  • 30. Copyright  2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright11-30Security Market Line (SML)Asset expectedreturn (E (Ri))Assetbeta (i)= E (RM) – RfE (RM)RfM = 1.0
  • 31. Copyright  2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright11-31The Capital Asset PricingModel (CAPM)• An equilibrium model of the relationship between risk andreturn.• What determines an asset’s expected return?– The risk-free rate—the pure time value of money.– The market risk premium—the reward for bearingsystematic risk.– The beta coefficient—a measure of the amount ofsystematic risk present in a particular asset.     ifMfi RRERRE CAPM
  • 32. Copyright  2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright11-32Calculation of Systematic Risk  MMii /R,R ~~CovWhere:Cov = covariancei = random distribution of return for asset iM = random distribution of return for themarketM = standard deviation of market returnR~R~
  • 33. Copyright  2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright11-33Covariance and Correlation• The covariance term measures how returns changetogether—measured in absolute terms.• The correlation coefficient measures how returns changetogether—measured in relative terms.• Correlation coefficient ranges between –1.0 and +1.0.• Where i = standard deviation of the return on asset i.    MiMiiM /R,R σσ~~Covρ 
  • 34. Copyright  2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright11-34Security Market Line versus CapitalMarket Line         ifMfipMfMfpβRRERRERRERRESML/CML * SML explains the expected return for all assets.* CML explains the expected return for efficient portfolios.
  • 35. Copyright  2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright11-35Risk of a PortfolioVariance of a two-asset portfolio is calculated as:weighted variance of the expected return foreach asset in the portfolio+twice the weighted covariance of the expectedreturn on the first asset with the expectedreturn on the second
  • 36. Copyright  2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright11-36Example—Risk of a PortfolioWeighting Std DeviationAsset A 0.3 0.26Asset B 0.7 0.13The covariance of the expected returns between A and B is0.017.     0.1466devStd0.02150.007140.0082810.0060840.0170.70.320.130.70.260.3Variance22
  • 37. Copyright  2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright11-37Problems with CAPM• Difficulties in estimating beta- thin trading- non-constant beta• Using CAPM- adding explanatory variables- measure of market return