1. 12- 1 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Fundamentals of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Alan J. Marcus Slides by Matthew Will Chapter 11 McGraw Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved Risk, Return and Capital Budgeting

2. 12- 2 Topics Covered  Measuring Market Risk  Beta  Risk and Return  CAPM  Capital Budgeting and Project Risk

3. 12- 3 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.

4. 12- 4 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.

5. 12- 5 Measuring Market Risk Example - continued

6. 12- 6 Measuring Market Risk  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

7. 12- 7 Measuring Market Risk Example - continued

8. 12- 8 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

9. 12- 9 Stock Betas Betas calculated with price data from January 2003 thru December 2007

10. 12- 10 Risk and Return Market Return (%) Vanguard Explorer Return (%) Vanguard Explorer Fund return

11. 12- 11 Risk and Return Vanguard Index 500 return Market Return (%) Vanguard Return (%)

12. 12- 12 Measuring Market Risk Market Risk Premium - Risk premium of market portfolio. Difference between market return and return on risk-free Treasury bills. Market Portfolio

13. 12- 13 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.

14. 12- 14 Measuring Market Risk Security Market Line - The graphic representation of the CAPM. 1.0

15. 12- 15 Security Market Line Return BETA rfrf 1.0 SML SML Equation = r f + B ( r m - r f )

16. 12- 16 Capital Asset Pricing Model R = r f + B ( r m - r f ) CAPM

17. 12- 17 Testing the CAPM Avg Risk Premium 1931-2005 Portfolio Beta 1.0 SML 30 20 10 0 Investors Market Portfolio Beta vs. Average Risk Premium

18. 12- 18 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 2007

19. 12- 19 Stock Expected Returns

20. 12- 20 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.

21. 12- 21 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

22. 12- 22 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

23. 12- 23 Web Resources