risk and return and capm

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Chapter 12 Risk, Return and

Capital Budgeting

Fundamentals of Corporate Finance

730g32

Linköpings Universitet

09/02/11

1



William Sharpe win Nobel Economic

prize for CAPM Sharpe's work- the Capital Asset Pricing Model

(CAPM), Capital Asset Prices: A Theory of

Market Equilibrium under Conditions of Risk

(1964).

2



Capital Asset Pricing Model: the CAPM

3



Security Market LineStock Return

.

rf

Market Portfolio

Market Return = rm

BETA

risk

1.0

Risk Free Return =

(Treasury bills)

4

2,0

ri



Company Cost of Capital

A companys cost of capital can be compared

to the CAPM required return

Required

return

Project Beta0.5

Company Cost of

Capital

3.8

0.2

0

SML

5



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.

6




0.8-1-60.2+1-5

1.8-1-4

0.2-1+3

1.8+1+2

0.8+1+1

%ReturnTurbo%ReturnMarketMonth

Example - continued

2,4/3=

0,8

-2,4/3=-0,8

7



% change of stock return / % change of

market return

8




0.8==21.6 F

When the market was up 1%, Turbo average %change was +0.8% over the first 3 months.

When the market was down 1%, Turbo average

% change was -0.8% over the next 3 monthperiod.

The average change of 1.6 % (0.8-(-0.8)) dividedby the change in the market 2% (1.0 -(-1.0))

produces a beta of 0.8.

Example - continued

9



Measuring Market RiskExample the relationship between market return and Turbo return.

1% change in market return, 0,8% change in turbo return.

10

-1 -0,8

-0,8 -0,64

-0,6 -0,48

-0,4 -0,32

-0,2 -0,16

0 0

0,2 0,16

0,4 0,32

0,6 0,48

0,8 0,64

1 0,8

-1

-0.8

-0.6

-0.4-0.2

0

0.2

0.4

0.6

0.8

1

-1.5 -1 -0.5 0 0.5 1 1.5

Turbo return %

market return %



Portfolio Betas

Diversification decreases variability fromunique risk, but not from market risk.

The beta of your portfolio will be an averageof the betas of the securities in the portfolio.

If you own all of the S&P Composite Index

stocks, you would have an average beta of 1.0

11



Some Stock Betas

B

Betas calculated with

price data fromJanuary 2003 thru

December 2007

Stock Beta

Amazon.com 2.39

Ford 2.46

Newmont Mining 0.84

Intel 1.59

Microsoft 1.04Dell Computer 1.27

Boeing 1.23

McDonalds 1.44

Pfizer 0.67

Dupont 1.24

Disney 1.00

ExxonMobil 0.81

IBM 1.13

Wal-Mart 0.24

Campbell Suop 0.46

GE 0.76

Heinz 0.5912



Risk and Return

-10

-8

-6

-4

-2

0

2

4

6

8

10

-10 -8 -6 -4 -2 0 2 4 6 8 10

Market Return (%)

V a n

g u a r d E x p l o r e r R

e t u r n ( % )

Vanguard Explorer Fund return

13

=1,39




Market Risk PremiumDifference between market return and return on

risk-free assets, Treasury bills. Note, market beta

equals to 1.

0

2

4

6

8

10

1214

0 0,2 0,4 0,6 0,8 1

Beta

E x p e c t e d R e t u r n ( % ) .

Market

Portfolio

14




CAPM - Theory of the relationship between risk andreturn which states that the expected risk

premium on any security equals its beta times the

market risk premium.

)r -(r +r =r ReturnExpected

r -r =iassetanyon premiumRisk

r -r = premiumrisk Market

f mf i

f i

f m

F

15




Security Market Line - The graphic representation of theCAPM. The required rate of return of any investmentis given by the security market line.

Beta

E x p e c t e d R

e t u r n ( % ) .

Rf

Rm

Security Market Line

1.0

16



Capital Budgeting & Project Risk

The project cost of capital depends on the risk

of the project and not on the risk of the

company.

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