12- 1 Chapter 12

Risk, Return and Capital Budgeting

• 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.

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

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Measuring Market Risk

B = = 0.81.62

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

BBetas calculated with price data from January 2003 thru December 2007

Stock BetaAmazon.com 2.39Ford 2.46Newmont Mining 0.84Intel 1.59Microsoft 1.04Dell Computer 1.27Boeing 1.23McDonalds 1.44Pfizer 0.67Dupont 1.24Disney 1.00ExxonMobil 0.81IBM 1.13Wal-Mart 0.24Campbell Suop 0.46GE 0.76Heinz 0.59

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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 (%)

Van

guar

d E

xplo

rer

Ret

urn

(%)

Vanguard Explorer Fund return

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Risk and Return

Vanguard Index 500 return

Market Return (%)

Van

guar

d R

etur

n (%

)

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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

Exp

ecte

d R

etu

rn (

%)

. 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

Exp

ecte

d R

etu

rn (

%)

.

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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Stock Expected Returns

)(rE

Stock Expected returnAmazon.com 19.8Ford 20.2Newmont Mining 8.9Intel 14.1Microsoft 10.3Dell Computer 11.9Boeing 11.6McDonalds 13.1Pfizer 7.7Dupont 11.7Disney 10.0ExxonMobil 8.7IBM 10.9Wal-Mart 4.7Campbell Suop 6.2GE 8.3Heinz 7.1

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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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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

Capital Budgeting & Project Risk

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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.

Capital Budgeting & Project Risk

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The monthly rates of return on three stocks versus the stock market index are given below.              

Ford Disney Newmont Mining

 

Beta 2.53 1.16 0.59

Standard deviation 77.40% 23.70% 38.50%

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Following are several months’ rates of return for Tumblehome Canoe Company. What is

Tumblehome’s beta?

   

 Month Market Return, %

Tumblehome Return, %

 

1 0.00 1.00

2 0.00 -1.00

3 (1.00) -2.50

4 (1.00) -0.50

5 1.00 2.00

6 1.00 1.00

7 2.00 4.00

8 2.00 2.00

9 (2.00) -2.00

10 (2.00) -4.00

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Consider the following two scenarios for the economy and the returns in each

scenario for the market portfolio, an aggressive stock A, and a defensive stock D.

Rate of Return

Scenario   Market Aggressive Stock ADefensive Stock

D

Bust   -8.00% -10.00% -6.00%

Boom   32.00% 40.00% 24.00%