The document defines key investment terms such as return, risk, expected return, and standard deviation. It provides examples of how to calculate return for an individual stock investment and explains how to determine the expected return and standard deviation for a portfolio consisting of multiple assets. Diversification across unrelated assets can reduce a portfolio's overall risk.
Fears in business operations are known as risks. They mainly affect external and international
relations and other business relations. In the event where operational risks are prominent, the
viability of a business in the future deteriorates and is a complete failure or crippling of the entire
business system. Risk aversion also takes into consideration proper analysis of future prospect of
a specific business before even making an ideal analysis of future prospect of a specific business
before engaging in capital investment
- See more at: http://www.customwritingservice.org/blog/risks-and-returns/
A Guide to capital budgeting and need for valuationArpit Amar
How a finance manager takes investment and financing decision and why and under what circumstances valuation of business in necessary is described in this presentation.
This presentation was made during my MBA program in Germany
Fears in business operations are known as risks. They mainly affect external and international
relations and other business relations. In the event where operational risks are prominent, the
viability of a business in the future deteriorates and is a complete failure or crippling of the entire
business system. Risk aversion also takes into consideration proper analysis of future prospect of
a specific business before even making an ideal analysis of future prospect of a specific business
before engaging in capital investment
- See more at: http://www.customwritingservice.org/blog/risks-and-returns/
A Guide to capital budgeting and need for valuationArpit Amar
How a finance manager takes investment and financing decision and why and under what circumstances valuation of business in necessary is described in this presentation.
This presentation was made during my MBA program in Germany
risk and return. Defining Return, Return Example, Defining Risk,Determining Expected Return , How to Determine the Expected Return and Standard Deviation, Determining Standard Deviation (Risk Measure), Portfolio Risk and Expected Return Example, Determining Portfolio Expected Return, Determining Portfolio Standard Deviation, Summary of the Portfolio Return and Risk Calculation, Total Risk = Systematic Risk + Unsystematic Risk,
Capital structure and cost of equity pdfDavid Keck
This slide set is a work in progress and is embedded in my Principles of Finance course, which is also a work in progress, that I teach to computer scientists and engineers
http://awesomefinance.weebly.com/
Return is the amount of gain or loss of an Investment for a particular period of time.
The future is uncertain. When we are dealing with the future, we assign probabilities to future returns. The Expected rate of return on an investment represents the mean probability distribution of possible future returns.
Risk reflects the chance that the actual return on an investment may be different than the expected return.
One way to measure risk is to calculate the variance and standard deviation of the distribution of returns.
We will once again use a probability distribution in our calculations.
This is a project example from MNQ, where the name has been changed. The financial overview here is for review purposes. Contact Scott Brown Realty at 972-464-7799 or visit www.USAHouses.org anytime.
1CHAPTER 6Risk, Return, and the Capital Asset Pricing Model.docxhyacinthshackley2629
1
CHAPTER 6
Risk, Return, and the Capital Asset Pricing Model
2
Topics in Chapter
Basic return concepts
Basic risk concepts
Stand-alone risk
Portfolio (market) risk
Risk and return: CAPM/SML
1
Value = + + +
FCF1
FCF2
FCF∞
(1 + WACC)1
(1 + WACC)∞
(1 + WACC)2
Free cash flow
(FCF)
Market interest rates
Firm’s business risk
Market risk aversion
Firm’s debt/equity mix
Cost of debt
Cost of equity
Weighted average
cost of capital
(WACC)
Net operating
profit after taxes
Required investments
in operating capital
−
=
Determinants of Intrinsic Value:
The Cost of Equity
...
For value box in Ch 4 time value FM13.
4
What are investment returns?
Investment returns measure the financial results of an investment.
Returns may be historical or prospective (anticipated).
Returns can be expressed in:
Dollar terms.
Percentage terms.
5
An investment costs $1,000 and is sold after 1 year for $1,100.
Dollar return:
Percentage return:
$ Received - $ Invested
$1,100 - $1,000 = $100.
$ Return/$ Invested
$100/$1,000 = 0.10 = 10%.
2
6
What is investment risk?
Typically, investment returns are not known with certainty.
Investment risk pertains to the probability of earning a return less than that expected.
The greater the chance of a return far below the expected return, the greater the risk.
2
7
Probability Distribution: Which stock is riskier? Why?
8
Consider the Following
Investment AlternativesEcon.Prob.T-BillAltaRepoAm F.MPBust 0.10 8.0% -22.0% 28.0% 10.0% -13.0%Below avg. 0.20 8.0 -2.0 14.7 -10.0 1.0Avg. 0.40 8.0 20.0 0.0 7.0 15.0Above avg. 0.20 8.0 35.0 -10.0 45.0 29.0Boom 0.10 8.0 50.0 -20.0 30.0 43.0 1.00
9
What is unique about the T-bill return?
The T-bill will return 8% regardless of the state of the economy.
Is the T-bill riskless? Explain.
5
10
Alta Inds. and Repo Men vs. the Economy
Alta Inds. moves with the economy, so it is positively correlated with the economy. This is the typical situation.
Repo Men moves counter to the economy. Such negative correlation is unusual.
7
11
Calculate the expected rate of return on each alternative.
r = expected rate of return.
rAlta = 0.10(-22%) + 0.20(-2%)
+ 0.40(20%) + 0.20(35%)
+ 0.10(50%) = 17.4%.
^
^
n
∑
r =
^
i=1
riPi.
12
Alta has the highest rate of return. Does that make it best?^rAlta 17.4%Market15.0Am. Foam13.8T-bill 8.0Repo Men 1.7
13
What is the standard deviation
of returns for each alternative?
σ = Standard deviation
σ = √ Variance = √ σ2
n
∑
i=1
= √
(ri – r)2 Pi.
^
14
= [(-22 - 17.4)20.10 + (-2 - 17.4)20.20
+ (20 - 17.4)20.40 + (35 - 17.4)20.20
+ (50 - 17.4)20.10]1/2
= 20.0%.
Standard Deviation of Alta Industries
11
15
T-bills = 0.0%.
Alta = 20.0%.
Repo = 13.4%.
Am Foam = 18.
This is the fifth presentation for the University of New England Graduate School of Business course GSB711 Managerial Finance, offered by Dr Subba Reddy Yarram. This presentation examines risk, return and the Capital Asset Pricing Model (CAPM).
Unveiling the Secrets How Does Generative AI Work.pdfSam H
At its core, generative artificial intelligence relies on the concept of generative models, which serve as engines that churn out entirely new data resembling their training data. It is like a sculptor who has studied so many forms found in nature and then uses this knowledge to create sculptures from his imagination that have never been seen before anywhere else. If taken to cyberspace, gans work almost the same way.
Falcon stands out as a top-tier P2P Invoice Discounting platform in India, bridging esteemed blue-chip companies and eager investors. Our goal is to transform the investment landscape in India by establishing a comprehensive destination for borrowers and investors with diverse profiles and needs, all while minimizing risk. What sets Falcon apart is the elimination of intermediaries such as commercial banks and depository institutions, allowing investors to enjoy higher yields.
Memorandum Of Association Constitution of Company.pptseri bangash
www.seribangash.com
A Memorandum of Association (MOA) is a legal document that outlines the fundamental principles and objectives upon which a company operates. It serves as the company's charter or constitution and defines the scope of its activities. Here's a detailed note on the MOA:
Contents of Memorandum of Association:
Name Clause: This clause states the name of the company, which should end with words like "Limited" or "Ltd." for a public limited company and "Private Limited" or "Pvt. Ltd." for a private limited company.
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Registered Office Clause: It specifies the location where the company's registered office is situated. This office is where all official communications and notices are sent.
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Liability Clause: It outlines the extent of liability of the company's members. In the case of companies limited by shares, the liability of members is limited to the amount unpaid on their shares. For companies limited by guarantee, members' liability is limited to the amount they undertake to contribute if the company is wound up.
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Capital Clause: This clause specifies the authorized capital of the company, i.e., the maximum amount of share capital the company is authorized to issue. It also mentions the division of this capital into shares and their respective nominal value.
Association Clause: It simply states that the subscribers wish to form a company and agree to become members of it, in accordance with the terms of the MOA.
Importance of Memorandum of Association:
Legal Requirement: The MOA is a legal requirement for the formation of a company. It must be filed with the Registrar of Companies during the incorporation process.
Constitutional Document: It serves as the company's constitutional document, defining its scope, powers, and limitations.
Protection of Members: It protects the interests of the company's members by clearly defining the objectives and limiting their liability.
External Communication: It provides clarity to external parties, such as investors, creditors, and regulatory authorities, regarding the company's objectives and powers.
https://seribangash.com/difference-public-and-private-company-law/
Binding Authority: The company and its members are bound by the provisions of the MOA. Any action taken beyond its scope may be considered ultra vires (beyond the powers) of the company and therefore void.
Amendment of MOA:
While the MOA lays down the company's fundamental principles, it is not entirely immutable. It can be amended, but only under specific circumstances and in compliance with legal procedures. Amendments typically require shareholder
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Implicitly or explicitly all competing businesses employ a strategy to select a mix
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(i.e., industry structure in the language of economics).
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4. 4
Defining ReturnDefining Return
Income receivedIncome received on an investment
plus any change in market pricechange in market price,
usually expressed as a percent of
the beginning market pricebeginning market price of the
investment.
DDtt + (PPtt - P- Pt-1t-1 )
PPt-1t-1
R =
5. 5
Return ExampleReturn Example
The stock price for Stock A was $10$10 per
share 1 year ago. The stock is currently
trading at $9.50$9.50 per share and shareholders
just received a $1 dividend$1 dividend. What return
was earned over the past year?
6. 6
Return ExampleReturn Example
The stock price for Stock A was $10$10 per
share 1 year ago. The stock is currently
trading at $9.50$9.50 per share and shareholders
just received a $1 dividend$1 dividend. What return
was earned over the past year?
$1.00$1.00 + ($9.50$9.50 - $10.00$10.00 )
$10.00$10.00RR = = 5%5%
7. 7
Defining RiskDefining Risk
What rate of return do you expect on yourWhat rate of return do you expect on your
investment (savings) this year?investment (savings) this year?
What rate will you actually earn?What rate will you actually earn?
Does it matter if it is a bank CD or a shareDoes it matter if it is a bank CD or a share
of stock?of stock?
The variability of returns fromThe variability of returns from
those that are expected.those that are expected.
8. 8
Determining ExpectedDetermining Expected
Return (Discrete Dist.)Return (Discrete Dist.)
R = Σ ( Ri )( Pi )
R is the expected return for the asset,
Ri is the return for the ith
possibility,
Pi is the probability of that return
occurring,
n is the total number of possibilities.
n
i=1
9. 9
How to Determine the ExpectedHow to Determine the Expected
Return and Standard DeviationReturn and Standard Deviation
Stock BW
Ri Pi (Ri)(Pi)
-.15 .10 -.015
-.03 .20 -.006
.09 .40 .036
.21 .20 .042
.33 .10 .033
Sum 1.00 .090.090
The
expected
return, R,
for Stock
BW is .09
or 9%
10. 10
Determining StandardDetermining Standard
Deviation (Risk Measure)Deviation (Risk Measure)
σσ = Σ ( Ri - R )2
( Pi )
Standard DeviationStandard Deviation, σσ, is a statistical
measure of the variability of a distribution
around its mean.
It is the square root of variance.
Note, this is for a discrete distribution.
n
i=1
11. 11
How to Determine the ExpectedHow to Determine the Expected
Return and Standard DeviationReturn and Standard Deviation
Stock BW
Ri Pi (Ri)(Pi) (Ri - R )2
(Pi)
-.15 .10 -.015 .00576
-.03 .20 -.006 .00288
.09 .40 .036 .00000
.21 .20 .042 .00288
.33 .10 .033 .00576
Sum 1.00 .090.090 .01728.01728
13. 13
Coefficient of VariationCoefficient of Variation
The ratio of the standard deviationstandard deviation of
a distribution to the meanmean of that
distribution.
It is a measure of RELATIVERELATIVE risk.
CV = σσ / RR
CV of BW = .1315.1315 / .09.09 = 1.46
15. 15
Determining ExpectedDetermining Expected
Return (Continuous Dist.)Return (Continuous Dist.)
R = Σ ( Ri ) / ( n )
R is the expected return for the asset,
Ri is the return for the ith observation,
n is the total number of observations.
n
i=1
16. 16
Determining StandardDetermining Standard
Deviation (Risk Measure)Deviation (Risk Measure)
n
i=1
σσ = Σ ( Ri - R )2
( n )
Note, this is for a continuous
distribution where the distribution is
for a population. R represents the
population mean in this example.
17. 17
ContinuousContinuous
Distribution ProblemDistribution Problem
Assume that the following list represents the
continuous distribution of population returns
for a particular investment (even though
there are only 10 returns).
9.6%, -15.4%, 26.7%, -0.2%, 20.9%,
28.3%, -5.9%, 3.3%, 12.2%, 10.5%
Calculate the Expected Return and
Standard Deviation for the population
assuming a continuous distribution.
18. 18
Let’s Use the Calculator!Let’s Use the Calculator!
Enter “Data” first. Press:
2nd
Data
2nd
CLR Work
9.6 ENTER ↓ ↓
-15.4 ENTER ↓ ↓
26.7 ENTER ↓ ↓
Note, we are inputting data
only for the “X” variable and
ignoring entries for the “Y”
variable in this case.
19. 19
Let’s Use the Calculator!Let’s Use the Calculator!
Enter “Data” first. Press:
-0.2 ENTER ↓ ↓
20.9 ENTER ↓ ↓
28.3 ENTER ↓ ↓
-5.9 ENTER ↓ ↓
3.3 ENTER ↓ ↓
12.2 ENTER ↓ ↓
10.5 ENTER ↓ ↓
21. 21
Certainty EquivalentCertainty Equivalent (CECE) is the
amount of cash someone would
require with certainty at a point in
time to make the individual
indifferent between that certain
amount and an amount expected to
be received with risk at the same
point in time.
Risk AttitudesRisk Attitudes
22. 22
Certainty equivalent > Expected value
Risk PreferenceRisk Preference
Certainty equivalent = Expected value
Risk IndifferenceRisk Indifference
Certainty equivalent < Expected value
Risk AversionRisk Aversion
Most individuals are Risk AverseRisk Averse.
Risk AttitudesRisk Attitudes
23. 23
Risk Attitude ExampleRisk Attitude Example
You have the choice between (1) a guaranteed
dollar reward or (2) a coin-flip gamble of
$100,000 (50% chance) or $0 (50% chance).
The expected value of the gamble is $50,000.
Mary requires a guaranteed $25,000, or more, to
call off the gamble.
Raleigh is just as happy to take $50,000 or take
the risky gamble.
Shannon requires at least $52,000 to call off the
gamble.
24. 24
What are the Risk Attitude tendencies of each?What are the Risk Attitude tendencies of each?
Risk Attitude ExampleRisk Attitude Example
Mary shows “risk aversion”“risk aversion” because her
“certainty equivalent” < the expected value of
the gamble..
Raleigh exhibits “risk indifference”“risk indifference” because her
“certainty equivalent” equals the expected value
of the gamble..
Shannon reveals a “risk preference”“risk preference” because
her “certainty equivalent” > the expected value
of the gamble..
25. 25
RP = Σ ( Wj )( Rj )
RP is the expected return for the portfolio,
Wj is the weight (investment proportion)
for the jth
asset in the portfolio,
Rj is the expected return of the jth
asset,
m is the total number of assets in the
portfolio.
Determining PortfolioDetermining Portfolio
Expected ReturnExpected Return
m
j=1
26. 26
Determining PortfolioDetermining Portfolio
Standard DeviationStandard Deviation
m
j=1
m
k=1
σσPP = Σ Σ Wj Wk σjk
Wj is the weight (investment proportion)
for the jth
asset in the portfolio,
Wk is the weight (investment proportion) for
the kth
asset in the portfolio,
σjk is the covariance between returns for
the jth
and kth
assets in the portfolio.
27. 27
Tip Slide: Appendix ATip Slide: Appendix A
Slides 5-28 through 5-30
and 5-33 through 5-36
assume that the student
has read Appendix A in
Chapter 5
28. 28
What is Covariance?What is Covariance?
σσ jk = σ j σ k rr jk
σj is the standard deviation of the jth
asset
in the portfolio,
σkis the standard deviation of the kth
asset
in the portfolio,
rjk is the correlation coefficient between the
jth
and kth
assets in the portfolio.
29. 29
Correlation CoefficientCorrelation Coefficient
A standardized statistical measure
of the linear relationship between
two variables.
Its range is from -1.0-1.0 (perfect
negative correlation), through 00
(no correlation), to +1.0+1.0 (perfect
positive correlation).
30. 30
Variance - Covariance MatrixVariance - Covariance Matrix
A three asset portfolio:
Col 1 Col 2 Col 3
Row 1 W1W1σ1,1 W1W2σ1,2 W1W3σ1,3
Row 2 W2W1σ2,1 W2W2σ2,2 W2W3σ2,3
Row 3 W3W1σ3,1 W3W2σ3,2 W3W3σ3,3
σj,k = is the covariance between returns for
th th
31. 31
You are creating a portfolio of Stock DStock D and StockStock
BWBW (from earlier). You are investing $2,000$2,000 in
Stock BWStock BW and $3,000$3,000 in Stock DStock D. Remember that
the expected return and standard deviation of
Stock BWStock BW is 9%9% and 13.15%13.15% respectively. The
expected return and standard deviation of Stock DStock D
is 8%8% and 10.65%10.65% respectively. The correlationcorrelation
coefficientcoefficient between BW and D is 0.750.75.
What is the expected return and standardWhat is the expected return and standard
deviation of the portfolio?deviation of the portfolio?
Portfolio Risk andPortfolio Risk and
Expected Return ExampleExpected Return Example
33. 33
Two-asset portfolio:
Col 1 Col 2
Row 1 WBWWBW σBW,BW WBWWD σBW,D
Row 2 WD WBW σD,BW WD WD σD,D
This represents the variance - covariance
matrix for the two-asset portfolio.
Determining PortfolioDetermining Portfolio
Standard DeviationStandard Deviation
34. 34
Two-asset portfolio:
Col 1 Col 2
Row 1 (.4)(.4)(.0173) (.4)(.6)(.0105)
Row 2 (.6)(.4)(.0105) (.6)(.6)(.0113)
This represents substitution into the
variance - covariance matrix.
Determining PortfolioDetermining Portfolio
Standard DeviationStandard Deviation
35. 35
Two-asset portfolio:
Col 1 Col 2
Row 1 (.0028) (.0025)
Row 2 (.0025) (.0041)
This represents the actual element values
in the variance - covariance matrix.
Determining PortfolioDetermining Portfolio
Standard DeviationStandard Deviation
36. 36
Determining PortfolioDetermining Portfolio
Standard DeviationStandard Deviation
σP = .0028 + (2)(.0025) + .0041
σP = SQRT(.0119)
σP = .1091 or 10.91%
A weighted average of the individual
standard deviations is INCORRECT.
37. 37
Determining PortfolioDetermining Portfolio
Standard DeviationStandard Deviation
The WRONG way to calculate is a
weighted average like:
σP = .4 (13.15%) + .6(10.65%)
σP = 5.26 + 6.39 = 11.65%
10.91% = 11.65%
This is INCORRECT.
38. 38
Stock C Stock D Portfolio
ReturnReturn 9.00% 8.00% 8.64%
Stand.Stand.
Dev.Dev. 13.15% 10.65% 10.91%
CVCV 1.46 1.33 1.26
The portfolio has the LOWEST coefficient
of variation due to diversification.
Summary of the PortfolioSummary of the Portfolio
Return and Risk CalculationReturn and Risk Calculation
39. 39
Combining securities that are not perfectly,
positively correlated reduces risk.
Diversification and theDiversification and the
Correlation CoefficientCorrelation Coefficient
INVESTMENTRETURN
TIME TIMETIME
SECURITY ESECURITY E SECURITY FSECURITY F
CombinationCombination
E and FE and F
40. 40
Systematic RiskSystematic Risk is the variability of return on
stocks or portfolios associated with changes
in return on the market as a whole.
Unsystematic RiskUnsystematic Risk is the variability of return
on stocks or portfolios not explained by
general market movements. It is avoidable
through diversification.
Total Risk = SystematicTotal Risk = Systematic
Risk + Unsystematic RiskRisk + Unsystematic Risk
Total RiskTotal Risk = SystematicSystematic RiskRisk +
UnsystematicUnsystematic RiskRisk
41. 41
Total Risk = SystematicTotal Risk = Systematic
Risk + Unsystematic RiskRisk + Unsystematic Risk
TotalTotal
RiskRisk
Unsystematic riskUnsystematic risk
Systematic riskSystematic risk
STDDEVOFPORTFOLIORETURN
NUMBER OF SECURITIES IN THE PORTFOLIO
Factors such as changes in nation’s
economy, tax reform by the Congress,
or a change in the world situation.
42. 42
Total Risk = SystematicTotal Risk = Systematic
Risk + Unsystematic RiskRisk + Unsystematic Risk
TotalTotal
RiskRisk
Unsystematic riskUnsystematic risk
Systematic riskSystematic risk
STDDEVOFPORTFOLIORETURN
NUMBER OF SECURITIES IN THE PORTFOLIO
Factors unique to a particular company
or industry. For example, the death of a
key executive or loss of a governmental
defense contract.
43. 43
CAPM is a model that describes the
relationship between risk and
expected (required) return; in this
model, a security’s expected
(required) return is the risk-free raterisk-free rate
plus a premiuma premium based on the
systematic risksystematic risk of the security.
Capital AssetCapital Asset
Pricing Model (CAPM)Pricing Model (CAPM)
44. 44
1. Capital markets are efficient.
2. Homogeneous investor expectations
over a given period.
3. Risk-freeRisk-free asset return is certain
(use short- to intermediate-term
Treasuries as a proxy).
4. Market portfolio contains only
systematic risksystematic risk (use S&P 500 Index
or similar as a proxy).
CAPM AssumptionsCAPM Assumptions
45. 45
Characteristic LineCharacteristic Line
EXCESS RETURN
ON STOCK
EXCESS RETURN
ON MARKET PORTFOLIO
BetaBeta =
RiseRise
RunRun
Narrower spreadNarrower spread
is higher correlationis higher correlation
Characteristic LineCharacteristic Line
46. 46
Calculating “Beta”Calculating “Beta”
on Your Calculatoron Your Calculator
Time Pd. Market My Stock
1 9.6% 12%
2 -15.4% -5%
3 26.7% 19%
4 -.2% 3%
5 20.9% 13%
6 28.3% 14%
7 -5.9% -9%
8 3.3% -1%
9 12.2% 12%
10 10.5% 10%
The Market
and My
Stock
returns are
“excess
returns” and
have the
riskless rate
already
subtracted.
47. 47
Calculating “Beta”Calculating “Beta”
on Your Calculatoron Your Calculator
Assume that the previous continuous
distribution problem represents the “excess
returns” of the market portfolio (it may still be
in your calculator data worksheet -- 2nd
Data ).
Enter the excess market returns as “X”
observations of: 9.6%, -15.4%, 26.7%, -0.2%,
20.9%, 28.3%, -5.9%, 3.3%, 12.2%, and 10.5%.
Enter the excess stock returns as “Y” observations
of: 12%, -5%, 19%, 3%, 13%, 14%, -9%, -1%,
12%, and 10%.
48. 48
Calculating “Beta”Calculating “Beta”
on Your Calculatoron Your Calculator
Let us examine again the statistical
results (Press 2nd
and then Stat )
The market expected return and standard
deviation is 9% and 13.32%. Your stock
expected return and standard deviation is
6.8% and 8.76%.
The regression equation is Y=a+bX. Thus, our
characteristic line is Y = 1.4448 + 0.595 X and
indicates that our stock has a beta of 0.595.
49. 49
An index of systematic risksystematic risk.
It measures the sensitivity of a
stock’s returns to changes in
returns on the market portfolio.
The betabeta for a portfolio is simply a
weighted average of the individual
stock betas in the portfolio.
What is Beta?What is Beta?
50. 50
Characteristic LinesCharacteristic Lines
and Different Betasand Different Betas
EXCESS RETURN
ON STOCK
EXCESS RETURN
ON MARKET PORTFOLIO
Beta < 1Beta < 1
(defensive)(defensive)
Beta = 1Beta = 1
Beta > 1Beta > 1
(aggressive)(aggressive)
Each characteristiccharacteristic
lineline has a
different slope.
51. 51
RRjj is the required rate of return for stock j,
RRff is the risk-free rate of return,
ββjj is the beta of stock j (measures
systematic risk of stock j),
RRMM is the expected return for the market
portfolio.
Security Market LineSecurity Market Line
RRjj = RRff + ββj(RRMM - RRff)
53. 53
Security Market LineSecurity Market Line
Obtaining Betas
Can use historical data if past best represents the
expectations of the future
Can also utilize services like Value Line, Ibbotson
Associates, etc.
Adjusted Beta
Betas have a tendency to revert to the mean of 1.0
Can utilize combination of recent beta and mean
2.22 (.7) + 1.00 (.3) = 1.554 + 0.300 = 1.854 estimate
54. 54
Lisa Miller at Basket Wonders is
attempting to determine the rate of return
required by their stock investors. Lisa is
using a 6% R6% Rff and a long-term marketmarket
expected rate of returnexpected rate of return of 10%10%. A stock
analyst following the firm has calculated
that the firm betabeta is 1.21.2. What is the
required rate of returnrequired rate of return on the stock of
Basket Wonders?
Determination of theDetermination of the
Required Rate of ReturnRequired Rate of Return
55. 55
RRBWBW = RRff + ββj(RRMM - RRff)
RRBWBW = 6%6% + 1.21.2(10%10% - 6%6%)
RRBWBW = 10.8%10.8%
The required rate of return exceeds
the market rate of return as BW’s
beta exceeds the market beta (1.0).
BWs RequiredBWs Required
Rate of ReturnRate of Return
56. 56
Lisa Miller at BW is also attempting to
determine the intrinsic valueintrinsic value of the stock.
She is using the constant growth model.
Lisa estimates that the dividend next perioddividend next period
will be $0.50$0.50 and that BW will growgrow at a
constant rate of 5.8%5.8%. The stock is currently
selling for $15.
What is the intrinsic valueintrinsic value of the
stock? Is the stock overover or
underpricedunderpriced?
Determination of theDetermination of the
Intrinsic Value of BWIntrinsic Value of BW
57. 57
The stock is OVERVALUED as
the market price ($15) exceeds
the intrinsic valueintrinsic value ($10$10).
Determination of theDetermination of the
Intrinsic Value of BWIntrinsic Value of BW
$0.50$0.50
10.8%10.8% - 5.8%5.8%
IntrinsicIntrinsic
ValueValue
=
= $10$10
58. 58
Security Market LineSecurity Market Line
Systematic Risk (Beta)
RRff
RequiredReturnRequiredReturn
Direction of
Movement
Direction of
Movement
Stock YStock Y (Overpriced)
Stock X (Underpriced)
59. 59
Small-firm EffectSmall-firm Effect
Price / Earnings EffectPrice / Earnings Effect
January EffectJanuary Effect
These anomalies have presented
serious challenges to the CAPM
theory.
Determination of theDetermination of the
Required Rate of ReturnRequired Rate of Return