analysis of securities

1. Chapter 11
Fundamentals 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

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11- 2
Topics Covered
Measuring Market Risk
Beta
Risk and Return
CAPM
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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Measuring Market Risk
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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Measuring Market Risk
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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Measuring Market Risk
B = = 0.8
1.6
2
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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Measuring Market Risk
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
.30
Heinz
.
H.J
.41
ExxonMobil
.46
Pfizer
.51
Mart
-
Wal
.76
Boeing
.90
s
McDonald'
.97
GE
1.34
Ford
1.64
er
DellComput
2.49
Amazon
Beta
Stock
B
Betas calculated with
price data from
January 2001 thru
December 2004

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11- 10
Risk and Return

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Risk and Return

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Measuring Market Risk
Market 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
Expected
Return
(%)
.
Market
Portfolio

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Measuring Market Risk
CAPM - 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 Risk
Security Market Line - The graphic representation
of the CAPM.
Beta
Expected
Return
(%)
.
Rf
Rm
Security Market Line
1.0

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Security Market Line
Return
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 Beta
1.0
SML
30
20
10
0
Investors
Market
Portfolio
Beta vs. Average Risk Premium

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Testing the CAPM
0.1
1
10
100 1926
1936
1946
1956
1966
1976
1986
1996
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
2004

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Stock Expected Returns
5.1
Heinz
.
H.J
5.9
ExxonMobil
6.2
Pfizer
6.6
Mart
-
Wal
8.3
Boeing
9.3
s
McDonald'
9.8
GE
12.4
Ford
14.5
er
DellComput
20.4
Amazon
Beta
Stock
)
(r
E

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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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Capital Budgeting & Project Risk
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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Capital Budgeting & Project Risk
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.