Instructor: Rogério Mazali Lecture 13: 11/30/2011 1

FINE Instructor: Rogério Mazali Fundamentals of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Alan J. Marcus McGraw Hill/Irwin 2 Chapter 12: Risk, Return, and Capital Budgeting

Agenda Measuring Market Risk Measuring Beta Betas for Amazon.com and Wal-Mart Total Risk and Market Risk Portfolio Betas Risk and Return Why the CAPM Makes Sense The Security Market Line How Well Does the CAPM work? Using the CAPM to Estimate Expected Returns Capital Budgeting and Project Risk Company vs. Project Risk Determinants of Project Risk 3

Measuring Market Risk Chapter 11: we have seen Use Variance and Std. Dev. As measures of total risk of an asset Risk can be reduced through diversification Two types of risk: Unique Risk (Idiosyncratic Risk) Market Risk (Systematic Risk) If investors are fully diversified, only market risk matters Investors will only be compensated by incurring in extra market risk, not extra total risk How to measure market risk? 4

Measuring Market Risk Different stocks have different exposures to market risk How exposed a firm is to market risk? We need a measure on how the firms stocks vary when compared to the market portfolio. Statisticians gave us: Covariance Correlation Coefficient 5

Measuring Market Risk Back to original question: how to measure market risk? Market Betas (or Market βs): measures how sensitive a security is to market movements Generally we estimate β by OLS with a linear regression R i = α i + β i * R m Generally, using the last 5 years of returns R i – Return on asset i R m – Return on the marker (ex S&P 500) α i & β i – Regression coefficients 6

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Example: 8

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10 Beta A = Cov(R A, R M ) / Var(R M ) = /

Measuring Market Risk β – tells us how sensitive a stock is to market movements β > 1: amplify the overall movements of the market 0 < β < 1: move in the same direction as the market, but not as far β = 0: no correlation with the market, asset has no market risk β < 0: asset is negatively correlated with the market, works as insurance against market downfalls 11

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Measuring Market Risk Amazon.com Wal-Mart 13

Measuring Market Beta Portfolio betas: The β of a portfolio equals the weighted average β of the component stocks Example: You have invested 40% of your money in asset A whose beta is 1.5 and 60% in asset B whose beta is 0.5. What is the portfolio beta? Portfolio beta = 0.4* *0.5 = 0.9 Market Portfolio beta: 14

Risk and Return We have seen that Unique risk can be eliminated through diversification Investors who can diversify only car about market risk We can use betas to predict expected returns Stocks are future investments: have to be compensated for patience: expected return > risk-free rate (T-Bill) Also, investors have to be compensated for incurring market risk, in the same proportion as their stocks are affected by changes in the market 15

Risk and Return This is known as the Capital Asset Pricing Model (CAPM). Example: R f = 5% Historical average market risk premium is 8.5% β = 1.5, β = 1, β = 0.5, β = 0, β = -1, 16

Risk and Return Security Market Line (SML): Graphical Representation of CAPM, shows risk-return trade-off 17

Risk and Return How well does CAPM do in practice? 18

Risk and Return How well does CAPM do in practice? 19

Capital Budgeting and Project Risk Company beta vs. project beta Suppose Dell Computers is consider a project in the pharmaceutical area. Does Dells beta tell anything about this projects market risk? A: No. Which beta is preferable? Dells or Pfizers? A: Pfizers. Example: suppose our firm have a project whose IRR is 11%. The project is assumed to be as risky as the market, the current T-Bill rate is 3%, and the market historical risk premium is 7%. Should the company go forward with the project? A: Yes. If the projects risk/return point lies above the SML, project should go ahead. 20

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