Risk, Return and Capital Budgeting Chapter 12 Risk, Return and Capital Budgeting Measuring Market Risk Beta Risk and Return CAPM Capital Budgeting and Project Risk

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. 3

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. 4

Measuring Market Risk Example - continued 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. 7

Measuring Market Risk Example - continued 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

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

Risk and Return Vanguard Explorer Fund return Vanguard Explorer Return (%) Market Return (%)

Risk and Return Vanguard Index 500 return Vanguard Return (%) Market Return (%)

Measuring Market Risk Market Risk Premium - Risk premium of market portfolio. Difference between market return and return on risk-free Treasury bills. Market Portfolio 11

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. 13

Measuring Market Risk Security Market Line - The graphic representation of the CAPM. 1.0 15

Security Market Line rf SML Equation = rf + B ( rm - rf ) Return SML 1.0 BETA SML Equation = rf + B ( rm - rf )

Capital Asset Pricing Model R = rf + B ( rm - rf ) CAPM

Stock Expected Returns 9

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. 16

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 19

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. 20

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%

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 -1.00 3 (1.00) -2.50 4 -0.50 5 2.00 6 7 4.00 8 9 (2.00) -2.00 10 -4.00

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 A Defensive Stock D Bust -8.00% -10.00% -6.00% Boom 32.00% 40.00% 24.00%