Title: Risk, Return, and Capital Budgeting Speaker: Rebecca Stull Created by: Gene Lai. online.wsu.edu

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1 Title: Risk, Return, and Capital Budgeting Speaker: Rebecca Stull Created by: Gene Lai online.wsu.edu

2 MODULE 9 RISK, RETURN, AND CAPITAL BUDGETING Revised by Gene Lai 12-2

3 Risk, Return and the Capital Budgeting This module introduces the quantitative techniques used to estimate the required returns on equity. It also establishes the relationship between market risk and the relative riskiness of the firm. 12-3

4 Outline Measuring Market Risk Portfolio Betas Risk and Return CAPM and Expected Return Security Market Line Capital Budgeting and Project Risk 12-4

5 Measuring Market Risk Market Portfolio - Portfolio of all assets (including rare coins and houses) in the economy. In practice, a broad stock market index, such as the S&P Composite, is used to represent the market. Beta - Sensitivity of a stock s return to the return on the market portfolio. 12-5

6 Beta and Market Risk Beta measures a stock s market risk. It shows a stock s volatility relative to the market. Beta shows how risky a stock is if the stock is held in a well-diversified portfolio. 12-6

7 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. 12-7

8 Measuring Market Risk Example - continued Month Market Return % Turbo Return %

9 Measuring Market Risk Example - continued When the market was up 1%, Turbo average % change was +0.8% (( )/3) When the market was down 1%, Turbo average % change was -0.8% Thus, beta or market risk is

10 How are betas calculated Run a regression of past returns on Stock i versus returns on the market. Example r IBM = a + b r S&P + e Where r = returns = (P 1 P 0 +Div 1 )/P 0 We need returns of IBM and S&P 500 for the last 60 months The slope of the regression line is defined as the beta coefficient

11 Measuring Beta Graphically 12-11

12 Beta If beta = 1.0, stock has average risk. If beta > 1.0, stock is riskier than average. If beta < 1.0, stock is less risky than average. Most stocks have betas in the range of 0.5 to

13 Can a beta be negative? Answer: Yes. If correlation coefficient between the return of that specific stock and that of the market or S&P 500 is negative, then beta is negative. In this case, the slope of the regression line will be negative. A negative beta is highly unlikely. The beta of gold can be negative

14 Stock Betas for Common Stocks (May April 2010) 12-14

15 Portfolio Beta The beta of your portfolio will be a weighted average of the betas of the securities in the portfolio. What would be the average beta if you owned all of the S&P Composite Index stocks? One. What is the beta of the risk-free return, U.S. Treasury Bills? Zero

16 Portfolio Beta: Example Example Calculate the beta of a portfolio that consists of 25% Ford, 25% Boeing, and 50% McDonald s. Company Beta Weight Beta Weight Ford Boeing McDonald's Portfolio Beta =

17 Measuring Market Risk: The Market Risk Premium Market Risk Premium - Risk premium of market portfolio; the difference between the market return and the return on risk-free Treasury bills. Let, r r f m Risk-free rate of return Market Return Market Risk Premium = r m r f 12-17

18 Market Risk Premium: Example Example: Let, r r f m 4% 12% Market Risk Premium = 8% Expected Return (%) market risk premium 8% rf 4% Market Portfolio (market return = 12%) Beta 12-18

19 Capital Asset Pricing Model (CAPM) Let r = expected return on any asset Market risk premium r - r Risk premium on any asset r- r m r r ( r r ) f m f or,* * Note: These are identical, the risk-free rate has just been moved to the right hand side. f f r r ( r r ) f m f 12-19

20 CAPM: Example Let: r r f m 4% 12% Thus, the Market Risk Premium = 8% Suppose 1.2 According to CAPM, the expected return on the asset is r r ( r r ) 4% 1.2 (8%) 13.6% f m f Suppose β=

21 Graphic Representation of CAPM Security Market Line - The relationship between expected return and beta. r m r f 12-21

22 How Well Does the CAPM Work? Almost everyone agrees high risk and high expected return concept Investors are concerned with the market risk that cannot be eliminated by diversification A good rule of thumb Hard to test because we do not know expected return Other factors such as size or market/book value ratio explain return better 12-22

23 Alternative Explanations to CAPM Small minus big: small stock performed better than big stocks even we adjusted for beta. High minus low book-to-market: high book-tomarket value stocks outperformed low book-tomarket value stocks. High book-to-market value stocks are value stocks Low book-to-market value stocks are glamour stocks

24 CAPM and Expected Returns 12-24

25 Project Risk and the Security Market Line Company Cost of Capital: Expected rate of return demanded by investors in a company, determined by the average risk of the company s securities Project Cost of Capital: Minimum acceptable expected rate of return on a project given its risk. Which should be used to assess the value of a proposed project? 12-25

26 Capital Budgeting & Project Risk Example - Based on the CAPM, what is the cost of capital of ABC Co. 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? (Assume risk premium is 10% and risk free rate is 4%.) 12-26

27 Capital Budgeting & Project Risk Example - Based on the CAPM, what is the cost of capital of ABC Co. 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? (Assume risk premium is 10% and risk free rate is 4%.) 1/3 Nuclear Parts Mfr.. Beta = 2.0 1/3 Computer Hard Drive Mfr.. Beta = 1.3 1/3 Dog Food Production Beta = 0.6 Answer: AVG. beta of assets = 1.3 = ( )/3 ABC Company has a cost of capital of 17% = ( (10))

28 Capital Budgeting & Project Risk The expected return for the new dog food production investment is r = (14-4 ) = 10% 10% reflects the opportunity cost of capital on an investment given the risk of the project (Dog food). We should use 10%, not 17%

29 Project Risk and the Security Market Line Should this project be accepted? Why? Yes. Because the project s rate of return is higher than the required rate of return. What does this imply, if anything, about this project s NPV? This implies the project has a positive NPV

30 Consider: Determinants of Project Risk 1. Operating Leverage and Project Risk: high operating leverage means high fixed costs and tends to have high betas. 2. The presence of non-diversifiable risk: earnings are strongly dependent on the state of the economy, tend to have high betas and high cost of capital

31 Don t Add Fudge Factors to Discount Rates Should you use higher discount rate if you believe the project has high risk such as liability lawsuit or political risk in certain country? No. Adjust expected cash flows not RRR (r)

Title: Introduction to Risk, Return and the Opportunity Cost of Capital Speaker: Rebecca Stull Created by: Gene Lai. online.wsu.

Title: Introduction to Risk, Return and the Opportunity Cost of Capital Speaker: Rebecca Stull Created by: Gene Lai online.wsu.edu MODULE 8 INTRODUCTION TO RISK AND RETURN, AND THE OPPORTUNITY COST OF