1. Chapter 11 Fundamentals of Corporate Finance Fifth Edition Slides by Matthew Will McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved Risk, Return and Capital Budgeting

2. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 11- 2 Topics Covered  Measuring Market Risk  Beta  Risk and Return  CAPM  Capital Budgeting and Project Risk

3. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 11- 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. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 11- 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. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 11- 5 Measuring Market Risk Example - continued

6. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 11- 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. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 11- 7 Measuring Market Risk Example - continued

8. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 11- 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. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 11- 9 Stock Betas Betas calculated with price data from January 2001 thru December 2004

10. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 11- 10 Risk and Return

11. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 11- 11 Risk and Return

12. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 11- 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. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 11- 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. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 11- 14 Measuring Market Risk Security Market Line - The graphic representation of the CAPM. 1.0

15. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 11- 15 Security Market Line Return BETA rfrf 1.0 SML SML Equation = r f + B ( r m - r f )

16. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 11- 16 Capital Asset Pricing Model R = r f + B ( r m - r f ) CAPM

17. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 11- 17 Testing the CAPM Avg Risk Premium 1931-2002 Portfolio Beta 1.0 SML 30 20 10 0 Investors Market Portfolio Beta vs. Average Risk Premium

18. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 11- 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 2004

19. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 11- 19 Stock Expected Returns

20. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 11- 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. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 11- 21 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

22. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 11- 22 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.

23. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 11- 23 Web Resources http://finance.yahoo.com http://moneycentral.msn.com http://money.cnn.com www.bloomberg.com www.morningstar.com www.duke.edu/~charvey Click to access web sites Internet connection required