Successfully reported this slideshow.
We use your LinkedIn profile and activity data to personalize ads and to show you more relevant ads. You can change your ad preferences anytime.

Chapters 8-10

1,339 views

Published on

Published in: Business, Economy & Finance
  • Be the first to comment

  • Be the first to like this

Chapters 8-10

  1. 1. Chapters 8, 9, 10 Financial Analysis and Decisions SCH-MGMT 640 Risk and Return Mila Getmansky Sherman Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved .
  2. 2. Capital Asset Pricing Model CAPM R = r f + B ( r m - r f )
  3. 3. Beta and Unique Risk 1. Total risk = diversifiable risk + market risk 2. Market risk is measured by beta, the sensitivity to market changes beta Expected return Expected market return 10% 10% - + <ul><li>10% </li></ul>+10% stock -10%
  4. 4. Beta and Unique Risk Market Portfolio - Portfolio of all assets 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.
  5. 5. Beta and Unique Risk
  6. 6. Beta and Unique Risk Covariance with the market Variance of the market
  7. 7. Beta
  8. 8. Testing the CAPM Avg Risk Premium 1931-2005 Portfolio Beta 1.0 Security Market Line 30 20 10 0 Investors Market Portfolio Beta vs. Average Risk Premium
  9. 9. Testing the CAPM Avg Risk Premium 1931-65 Portfolio Beta 1.0 SML 30 20 10 0 Investors Market Portfolio Beta vs. Average Risk Premium
  10. 10. Testing the CAPM Avg Risk Premium 1966-2005 Portfolio Beta 1.0 SML 30 20 10 0 Investors Market Portfolio Beta vs. Average Risk Premium
  11. 11. CAPM Assumptions <ul><li>Two benchmarks: Treasury bills and market portfolio </li></ul><ul><li>U.S. Treasury bills are risk-free (risk = 0) </li></ul><ul><li>Investors can borrow money at the same rate at which they lend </li></ul>
  12. 12. Arbitrage Pricing Theory <ul><li>Alternative to CAPM </li></ul><ul><li>Expected Risk </li></ul><ul><li>Premium = r - r f </li></ul><ul><li> = B factor1 (r factor1 - r f ) + B f2 (r f2 - r f ) + … </li></ul><ul><li>Return = a + b factor1 (r factor1 ) + b f2 (r f2 ) + … </li></ul>
  13. 13. Arbitrage Pricing Theory <ul><li>Estimated risk premiums for taking on risk factors </li></ul><ul><li>(1978-1990) </li></ul>
  14. 14. Three Factor Model <ul><li>Steps to Identify Factors </li></ul><ul><li>Identify a reasonably short list of macroeconomic factors that could affect stock returns </li></ul><ul><li>Estimate the expected risk premium on each of these factors ( r factor 1 − r f , etc.); </li></ul><ul><li>Measure the sensitivity of each stock to the factors ( b 1 , b 2 , etc.). </li></ul>
  15. 15. Testing the CAPM High-minus low book-to-market Return vs. Book-to-Market Dollars (log scale) Small minus big http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html
  16. 16. Three Factor Model
  17. 17. Topics Covered <ul><li>Company and Project Costs of Capital </li></ul><ul><li>Measuring the Cost of Equity </li></ul><ul><li>WACC (Weighted Average Cost of Capital) </li></ul>
  18. 18. Company Cost of Capital <ul><li>A company’s cost of capital can be compared to the CAPM required return </li></ul>Required return Project Beta 1.13 Company Cost of Capital 12.9 5.0 0 SML
  19. 19. Company Cost of Capital
  20. 20. Debt and WACC <ul><li>r assets = WACC = r debt D/V + r equity E/V </li></ul><ul><li>After tax WACC = (1-T c )r debt D/V + r equity E/V </li></ul>IMPORTANT E, D, and V are all market values of Equity, Debt and Total Firm Value r equity = r f + B equity ( r m - r f ) V= D + E
  21. 21. Capital Structure & COC Expected return (%) B debt B assets B equity R rdebt =8 R assets =12.2 R equity =15 Expected Returns and Betas prior to refinancing
  22. 22. Measuring Betas <ul><li>The SML shows the relationship between return and risk </li></ul><ul><li>CAPM uses Beta as a proxy for risk </li></ul><ul><li>Other methods can be employed to determine the slope of the SML and thus Beta </li></ul><ul><li>Regression analysis can be used to find Beta </li></ul>
  23. 23. Measuring Betas Intel Computer Slope determined from plotting the line of best fit. Price data: July 1996 – June 2001 R 2 = .29 B = 1.54
  24. 24. Measuring Betas Intel Computer Slope determined from plotting the line of best fit. Price data: July 2001 – June 2006 R 2 = .30 B = 2.22
  25. 25. Measuring Betas Heinz Slope determined from plotting the line of best fit. Price data: July 1996 – June 2001 R 2 = .18 B = .47
  26. 26. Measuring Betas Heinz Slope determined from plotting the line of best fit. Price data: July 2001 – June 2006 R 2 = .15 B = .36
  27. 27. Estimated Betas

×