SESSION 3:

RISK AND RETURN I

MODERN FINANCE AND CORPORATE FINANCE

NIKOLAOS KAVADIS
nk.ccg@cbs.dk
 INTRODUCTION
• Based on the efficient market hypothesis, i.e., due to competition, NPV=0. The price of a share equals the
present value of all expected cash flows when discounted at a cost of capital that reflects its risk.
• Thus, securities with equivalent risk should have the same expected return.
 How do we define “equivalent risk”?
 Why are there differences in the average level and variability in investment returns?

• A theory that explains the relationship between average returns and the variability of returns; then derive
the risk premium that investors require to hold different securities and investments; then use this theory to
determine the cost of capital for an investment opportunity.
 Explain “how much” investors demand in terms of a higher expected return to bear a given level of
risk.
 Develop tools to measure risk and return.

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 MEASURES OF RISK AND RETURN

Probability distributions
• Example: A stock currently trades at $100 per share. We believe that in one year there is 25% chance the
share price will be $140, 50% chance it will be $110, 25% chance it will be $80. The firm pays no
dividends, thus payoffs correspond to returns of 40%, 10% and –20%.

Expected (mean) return = E[R] = ΣR pR * R, where pR is probability that a return R will occur.
• Based on the previous example: E[R] = 25%*(–0.20) + 50%*(0.10) + 25%*(0.40) = 10%

Two common measures of the risk of a probability distribution:

Variance = expected squared deviation from the mean
Standard deviation = squared root of the Variance

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 MEASURES OF RISK AND RETURN

Variance of the return distribution

Var(R) = E[(R – E[R])2 ] = ΣR pR * (R – E[R])2 =
= 25%*(–0.20–0.10)2 + 50%*(0.10–0.10)2 + 25%*(0.40–0.10)2 = 0.045

Standard deviation of the return distribution

SD(R) = √ Var(R) =
= √ 0.045 = 21.2%

Standard deviation of a return = its volatility

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 MEASURES OF RISK AND RETURN

Historical volatility and return of different types of investment, 1926-2014

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 TYPES OF RISK
Limitations

Many stocks are very volatile and on the market for few years (thus, little data to rely upon). Given the
typically large estimation error, search for an alternative strategy to measure risk, determine the relation
between risk and return, and estimate expected return.

If we look at volatility and return of individual stocks, rather than the large portfolios (e.g., S&P500), there
is no clear relationship between expected return and volatility (i.e., expected return not rising
proportionately with volatility)

Thus, while volatility is a reasonable measure of risk when evaluating a large portfolio, it is not adequate to
explain the returns of individual securities.
 Why the S&P500 portfolio is much less risky than all the 500 stocks individually?

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 TYPES OF RISK

Common risk = affects all simultaneously (e.g., earthquake affecting all homes, risk is perfectly correlated
across all homes)

Independent risk = specific to a unit (e.g., theft, uncorrelated and independent across homes)
 When risks are independent, some homeowners are lucky and others unlucky
 Diversification = the averaging out of independent risks in a large portfolio

 Diversification reduces risk

 The risk of a portfolio depends on whether the individual risks within it are common or
independent. Independent risks are diversified in a large portfolio, whereas common risks are not

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 TYPES OF RISK

Implications for stock portfolios and their diversification

• Firm-specific news, good or bad for the firm itself: Any fluctuations are independent risks, i.e., firm-
specific, idiosyncratic, unique, or diversifiable risk.
• Market-wide news, about the economy as a whole, e.g., a central bank lowers interest rates: Fluctuations
that are due to market-wide news are systematic, market, undiversifiable risk.
In a stock portfolio with only idiosyncratic risks, volatility can be diversified and (close to be) eliminated as the
number of firms (stocks) in the portfolio increases. This is not the case when we face systematic risk only.

Competition between investors drives the return of idiosyncratic-risk-firms down to the risk-free return
(otherwise an arbitrage situation, where they would borrow at the risk-free rate to invest in firms with
diversifiable risk and earn a return above the risk-free rate without taking on significant risk)
 The risk premium for diversifiable risk is zero, thus investors are not compensated for holding
firm-specific risk (because they can diversify away “for free” their portfolios)

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 TYPES OF RISK

Implications for stock portfolios and their diversification (2)

However, diversification does not reduce systematic risk.
 Investors may demand a risk premium to hold systematic risk. Otherwise, they would invest in
risk-free bonds (but sacrificing expected returns)
 Risk premium of a security is determined by its systematic risk.

Thus, volatility may be a reasonable measure of a well-diversified portfolio but it is not an appropriate metric
for an individual security, as there is no clear relation between volatility and average returns for individual
securities.
 How to measure systematic risk?

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 SYSTEMATIC RISK
Mean reversion (cyclicity)
Past low returns used to predict future high returns. No evidence for short time horizons, some evidence for
long horizons, but we don’t know if it will continue. Thus, buy-and-hold is not optimal, as it rests on the idea
that past returns predict future returns.
 Long horizon does not necessarily reduce risk

Identifying systematic risk: The market portfolio

How sensitive the stock is to systematic shocks that affect the economy as a whole = How much change in the
stock’s return for each 1% change in the return of a portfolio that fluctuates solely due to systematic risk.
 One of the key-questions in modern finance: Find a portfolio that contains only systematic risk =
a portfolio that cannot be diversified further = efficient portfolio = the market portfolio = a
portfolio of all stocks and securities traded in the capital markets. E.g., S&P500 used as an
approximation (the assumption being that it is large enough)

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 SYSTEMATIC RISK
Identifying systematic risk: The market portfolio (2)

Beta (β) of a security = the expected % change in its return given a 1% change in the market portfolio’s return;
sensitivity of a security to market-wide risk factors = How sensitive its underlying revenues and cash flows are to
general economic conditions.

Example: When the economy is strong, market portfolio increases by 47%; when the economy is weak, it
decreases by 25%. If firms only under Systematic risk have return 40% when strong economy, and –20% when
weak economy: What’s the beta of such firms?
The systematic risk of the strength of the economy is 47% – (–25%) = 72% change in the return of the market
portfolio. Those firms’ return changes by 40% – (–20%) = 60% on average. => 60%/72% = 0.833 = Beta.

Average beta of a stock in the market is about 1. Cyclical industries are likely to be more sensitive to systematic
risk with betas exceeding 1 (i.e., in industries where revenues and profits vary greatly over the business cycle)

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 SYSTEMATIC RISK
Estimating the risk premium
Look at the risk premium investors demand for investing in systematic risk = what they earn is the difference
between the market portfolio’s expected return and the risk-free interest rate:
Market Risk Premium = E[R Mkt ] – r𝑓
E.g., if r𝑓 is 5% and the expected return of the market portfolio is 11%, the market risk premium is 6%.

It is investors’ reward for holding a portfolio with a beta of 1 = the market portfolio itself.
E.g., for an investment opportunity with a beta of 2 (carries twice as much systematic risk as an investment in the
market portfolio) we will ask twice the risk premium to invest in it, given that for each DKK we invest in it, we
could invest twice as much in the market portfolio and be exposed to the exact same amount of systematic risk.
 We can use the beta of the investment to determine the scale of the investment in the market
portfolio that has equivalent systematic risk.

Beta ≠ Volatility, as volatility measures total risk. No necessary relation between them.

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 SYSTEMATIC RISK

Estimating the Cost of Capital r𝑰 of an Investment I from its Beta:

r𝐼 = Risk-free interest rate + β𝐼 * Market Risk Premium = r𝑓 + β𝐼 *(E[R Mkt ] – r𝑓 )

 Capital Asset Pricing Model (CAPM)

 The most important method for estimating the cost of capital that is used in practice, and thus most
important model on the risk-return relationship

 (Reminder) As managers, ensure the investment has NPV>0, which requires knowing the cost of
capital of the investment opportunity. To know this, CAPM is the main method to use.

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 CAPITAL ASSET PRICING MODEL

• Under its assumptions: Efficient portfolio = market portfolio of all stocks and securities
 The expected return of any security depends upon its beta with the market portfolio.

• How to calculate the expected return and volatility of a portfolio?

• How can an investor create an efficient portfolio out of individual stocks?
• What are the implications if all investors do the same?

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 CAPITAL ASSET PRICING MODEL
We can describe a portfolio by its portfolio weights = the fraction of the total investment in the portfolio held
in each individual investment:
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑖
𝑥𝑖 =
𝑇𝑜𝑡𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜

These portfolio weights add up to 1.

Return of the portfolio = 𝑅𝑝 = weighted average of the returns on the investments in the portfolio
𝑅𝑝 = 𝑥1 𝑅1 + 𝑥2 𝑅2 + … + 𝑥𝑁 𝑅𝑁 = Σ𝑖 𝑥𝑖 𝑅𝑖
Expected return of a portfolio = E[𝑅𝑝 ] = E[Σ𝑖 𝑥𝑖 𝑅𝑖 ] = Σ𝑖 E 𝑥𝑖 𝑅𝑖 = Σ𝑖 𝑥𝑖 E 𝑅𝑖

In terms of risk, some can be diversified away, but then some will remain (systematic, common risk)

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 CAPITAL ASSET PRICING MODEL
Volatility of a 2-Stock Portfolio
Example: 3 stocks with same average return and volatility, but the pattern of their returns differs. By
recombining them in two separate portfolios, their volatilities can become different.

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 CAPITAL ASSET PRICING MODEL
Volatility of a 2-Stock Portfolio (2)

Two important phenomena:

1. By combining stocks into a portfolio, we reduce risk through diversification. Because the stock prices do not
move identically, some of the risk is averaged out in a portfolio. Hence, portfolios can have lower risk than
individual stocks.
2. The amount of risk eliminated in a portfolio depends on the degree to which the stocks face common risks and
their prices move together.
Case 1: the portfolio of two airline stocks: Because the two stocks perform well or bad at the same time, the
portfolio has volatility that is only slightly lower than that of the individual stocks.
Case 2: the portfolio of the stock of an airline company and of an oil company do not move together but probably
in opposite directions, hence this portfolio is much less risky
 This benefit of diversification is costless as there is no reduction in the average return.
 Importance to know the degree to which the stocks face common risks & their returns co-move.

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 CAPITAL ASSET PRICING MODEL
Covariance = the expected product of the deviations of two returns from their means.
Covariance between returns 𝑅𝑖 and 𝑅𝑗 = 𝐶𝑜𝑣(𝑅𝑖 , 𝑅𝑗 ) = E[(𝑅𝑖 – E[𝑅𝑖 ])(𝑅𝑗 – E[𝑅𝑗 ])]
1
Estimating covariance from historical data = 𝐶𝑜𝑣(𝑅𝑖 , 𝑅𝑗 ) = 𝑇 −1 Σ 𝑡 (𝑅𝑖,𝑡 – 𝑅𝑖 𝐴𝑉𝐺 )(𝑅𝑗,𝑡 – 𝑅𝑗 𝐴𝑉𝐺 )

If the stocks move together: Positive covariance

If the stocks move in the opposite direction: Negative covariance

Correlation = the covariance of the returns divided by the standard deviation of each return.
𝐶𝑜𝑣(𝑅𝑖 , 𝑅𝑗 )
𝐶𝑜𝑟𝑟(𝑅𝑖 , 𝑅𝑗 ) =
𝑆𝐷 𝑅𝑖 𝑆𝐷(𝑅𝑗 )

Stock returns will tend to move together when affected similarly by economic events. Thus, stocks in the same
industry tend to have more highly correlated returns than stocks in different industries.

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 CAPITAL ASSET PRICING MODEL

General rules:
• The variance of a portfolio is equal to the weighted average covariance of each stock with the portfolio.
 The risk of a portfolio depends on how each stock’s return moves in relation to it.
• The variance of a portfolio is equal to the sum of the covariances of the returns of all pairs of stocks in the
portfolio multiplied by each of their portfolio weights.
 Overall variability of the portfolio depends on the total co-movement of the stocks within it.

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 CAPITAL ASSET PRICING MODEL
Equally weighted portfolio volatility & number of stocks:

• As the number of stocks grows, the volatility declines.

• The benefit of diversification is most significant initially: Much larger when going from 1 to 2 stocks than from
100 to 101.
• Empirical rule: Almost all benefit of diversification can be achieved with about 30 stocks.

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 CAPITAL ASSET PRICING MODEL
How to create an efficient portfolio?

Efficient portfolios = those offering the highest possible expected return for a given level of volatility (= the
efficient frontier)
• Adding new investment opportunities allows for greater diversification and moves the curve to the left, i.e.,
less volatility, for same (or possibly higher) return
 To arrive to the best possible set of risk and return opportunities, we should keep adding stocks until
all investment opportunities are represented = optimal diversification
• Another way besides diversification to reduce risk is to keep some of our money in a safe, no-risk investment
like Treasury Bills.

The efficient “frontier” of investments contains risk among which investors may choose. But if we
combine these risky securities with a risk-free investment, we can identify a unique optimal
portfolio of risky securities that does not depend on an investor’s tolerance for risk.

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 CAPITAL ASSET PRICING MODEL

As we increase the fraction x invested in P, our risk Investor preferences could affect how much to invest
and risk premium increase proportionally. in the tangent portfolio vs. the risk-free investment.

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 CAPITAL ASSET PRICING MODEL
By combining the risk-free asset with a portfolio somewhat higher on the efficient frontier, we get a steeper line
than the line through P = We earn higher return at any level of volatility.
 To get the maximum possible expected return for any level of volatility, we must find the portfolio
that generates the steepest line, when combined with the risk-free investment.
 The slope of the line through a given portfolio P = Sharpe ratio
𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝐸𝑥𝑐𝑒𝑠𝑠 𝑅𝑒𝑡𝑢𝑟𝑛 E[𝑅𝑃 ] − 𝑟𝑓
𝑆ℎ𝑎𝑟𝑝𝑒 𝑟𝑎𝑡𝑖𝑜 = =
𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑉𝑜𝑙𝑎𝑡𝑖𝑙𝑖𝑡𝑦 𝑆𝐷 𝑅𝑃
• It measures the ratio of reward-to-volatility provided by a portfolio.
• The optimal portfolio to combine with the risk-free asset is the one with the highest Sharpe ratio =
Tangent portfolio = the best risk-return trade-off.
 The efficient portfolio is the tangent portfolio, i.e., the portfolio with the highest Sharpe ratio in the
economy. The optimal portfolio of risky investments no longer depends on how conservative or risk-
seeking the investor is.

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 CAPITAL ASSET PRICING MODEL
What are the implications of this result for the firm’s cost of capital?

If a firm wants to raise capital, investors must find it attractive to increase their investment in it.
We have an arbitrary portfolio P, we sell some risk-free assets (or borrow money) and invest what we get in an
investment i. Two consequences:
1. We are giving up the risk-free return and replacing it with i’s return our expected return will increase by i’s
excess return: E[𝑅𝑖 ] – 𝑟𝑓
2. Volatility: We will add the risk that i has in common with our portfolio, the rest of i’s risk will be diversified.
Incremental risk is measured by i’s volatility multiplied by its correlation with P: SD 𝑅𝑖 ∗ Corr(𝑅𝑖 , 𝑅𝑝 )

Is the gain in return from investing in i adequate to make up for the increase in risk?

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 CAPITAL ASSET PRICING MODEL
What are the implications of this result for the firm’s cost of capital? (2)
Another way to increase our risk is to invest more in portfolio P itself. In that case, P’s Sharpe ratio tell us how
much the return should increase for a given increase in risk.
The investment in i increases risk by SD 𝑅𝑖 ∗ Corr(𝑅𝑖 , 𝑅𝑝 )
It offers a larger increase in return than what we could have gotten from P alone if:
E[𝑅𝑃 ] − 𝑟𝑓
E[𝑅𝑖 ] – 𝑟𝑓 > SD 𝑅𝑖 ∗ Corr(𝑅𝑖 , 𝑅𝑝 ) ∗ 𝑆𝐷 𝑅𝑃

Additional return Incremental Return per unit of

from investment i volatility from volatility available
investment i from portfolio P

Additional return from taking the same risk investing

in P

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 CAPITAL ASSET PRICING MODEL
Based on the above, we define the beta of investment i with portfolio P:
𝑃 𝑆𝐷 𝑅𝑖 ∗ 𝐶𝑜𝑟𝑟 𝑅𝑖 , 𝑅𝑃
β𝑖 is defined as and measures the sensitivity of the investment i to the fluctuations of
𝑆𝐷 𝑅𝑃
the portfolio P. For each 1% change in the portfolio’s return, investment i’s return is expected to change
𝑃
by β𝑖 % due to risks that i has in common with P.

From the above 2 formulas:

𝑃
E[𝑅𝑖 ] > 𝑟𝑓 + β𝑖 ∗ (E[𝑅𝑃 ] − 𝑟𝑓 )
That is, increasing the amount invested in i will increase the Sharpe ratio of portfolio P if its expected return
E[𝑅𝑖 ] exceeds its required return given portfolio P, which is defined as follows:
𝑃
𝑟𝑖 is defined as 𝑟𝑓 + β𝑖 ∗ (E[𝑅𝑃 ] − 𝑟𝑓 )
Required return = expected return that is necessary to compensate for the risk investment i will contribute to
the portfolio.

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 CAPITAL ASSET PRICING MODEL
Thus, if a security’s expected return exceeds its required return, then we can improve the performance of
portfolio P by adding more of the security. How much more should we add?
We add until E[𝑅𝑖 ] = 𝑟𝑖 where 𝑟𝑖 is the required return. At this point we reach “optimality”.
If E[𝑅𝑖 ] < 𝑟𝑖 we should reduce our holdings of i.
 Thus, assuming no restrictions to trade, we add securities until the expected return equals the
required return.
 The portfolio is efficient if and only if the expected return of every available security
equals its required return.
𝑒𝑓𝑓
Expected Return of a Security E[𝑅𝑖 ] = 𝑟𝑖 which is defined as 𝑟𝑓 + β𝑖 ∗ (E[𝑅𝑒𝑓𝑓 ] − 𝑟𝑓 )
Where 𝑅𝑒𝑓𝑓 is the return of the efficient portfolio, the portfolio with the highest Sharpe ratio of any portfolio in
the economy.
It shows that we can determine the appropriate risk premium for an investment from its beta with the efficient
portfolio.

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 CAPITAL ASSET PRICING MODEL

The efficient or tangent portfolio (= the one with the highest possible Sharpe ratio of any portfolio in the market)
provides the benchmark that identifies the systematic risk in the economy.

What the connection is between the market portfolio and the efficient portfolio?

To implement the efficient portfolio, we have to know the expected return, volatilities, and correlations between
investments.

The three assumptions of CAPM:

1. Investors can buy and sell all securities at competitive market prices (without incurring taxes or transaction
costs) and can borrow and lend at the risk-free interest rate.
2. Investors hold only efficient portfolios of traded securities.

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 CAPITAL ASSET PRICING MODEL
If all investors use publicly available information sources, then their estimates are likely to be similar. Thus, it is
not unreasonable to consider a case where all investors have the same estimates concerning future investments
and returns = homogeneous expectations.
3. Investors have homogeneous expectations regarding the volatilities, correlations, and expected returns of
securities.
• Each investor will identify the same portfolio as having the highest Sharpe ratio.
• All investors will demand the same efficient portfolio of risky securities = the tangent portfolio.
• If every investor is holding the tangent portfolio, then the combined portfolio of risky securities of all investors
must also equal the tangent portfolio.
• Since each security is owned by someone, the sum of all investors’ portfolios must equal the portfolio of all
risky securities available in the market = the market portfolio.
 Thus, the efficient, tangent portfolio of risky securities must equal the market portfolio.

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 CAPITAL ASSET PRICING MODEL
The above mean that demand must equal supply: If a security was not part of the efficient portfolio, then no
investor would want to own it, and demand for that security would not equal its supply. This security’s price
would fall, causing its expected return to rise until it becomes an attractive investment.
 Prices in the market will adjust so that the market portfolio and the efficient portfolio coincide, and
demand equals supply.
When the tangent line goes through the market portfolio = capital market line.

*** ADD PIC WITH FIGURE 11.11 PAGE 419 ***

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 CAPITAL ASSET PRICING MODEL
Conclusions

• Under the CAPM assumptions, efficient portfolio = market portfolio. Thus, if we don’t know the expected
return of a security or the cost of capital of an investment, we can use the CAPM to find it by using the market
portfolio as a benchmark.

• The CAPM equation for the expected return: E[𝑅𝑖 ] = 𝑟𝑖 = 𝑟𝑓 + β𝑖 ∗ (E[𝑅𝑀𝑘𝑡 ] − 𝑟𝑓 )

β𝑖 ∗ (E[𝑅𝑀𝑘𝑡 ] − 𝑟𝑓 ) = the risk premium for security i

𝑆𝐷 𝑅𝑖 ∗ 𝐶𝑜𝑟𝑟 𝑅𝑖 , 𝑅𝑀𝑘𝑡
β𝑖 = 𝑆𝐷 𝑅𝑀𝑘𝑡

𝑆𝐷 𝑅𝑖 ∗ 𝐶𝑜𝑟𝑟 𝑅𝑖 , 𝑅𝑀𝑘𝑡 indicating the volatility of i that is common with the market

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 CAPITAL ASSET PRICING MODEL
Conclusions (2)

• The beta of a security measures its volatility due to market risk relative to the market as a whole, and thus
captures the security’s sensitivity to market risk.
• Following the Law of One Price, in a competitive market, investments with similar risk should have the same
expected return. Because investors can eliminate firm-specific risk by diversifying their portfolios, the right
measure of risk is the investment’s beta with the market portfolio β𝑖 .
• The beta of a portfolio is the weighted average beta of the securities in the portfolio.
• The risk premium for any investment is proportional to its beta with the market. Thus, the CAPM equation
implies a linear relation between risk and return (see also “security market line” showing stock’s expected
return as a function of its beta with the market)
 CAPM while not perfect (e.g., not every investor holds the market portfolio), it is widely regarded as a
useful approximation and a practical means to estimate a security’s expected return and an investment’s
cost of capital.

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 ESTIMATING THE COST OF CAPITAL
Evaluating investment opportunities requires managers to estimate the cost of capital, which should include a
risk premium that compensates investors for taking on the risk of the new project.
Cost of capital = best expected return available in the market on investments with similar risk.
Because market risk cannot be diversified (i.e., systematic risk), cost of capital is determined by market risk.
Easy to estimate, when the data are given. But we may need to
(1) construct the market portfolio and determine its expected excess return over the risk-free interest rate
(2) estimate the stock’s beta, i.e., sensitivity to market portfolio

The Market Portfolio

Market Value 𝑀𝑉𝑖 = Number of Shares of i Outstanding * Price of i per Share

The portfolio weights of each security xi are calculated as follows:

𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑖 𝑀𝑉𝑖
𝑥𝑖 = =
𝑇𝑜𝑡𝑎𝑙 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐴𝑙𝑙 𝑆𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠 𝑖𝑛 𝑡ℎ𝑒 𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 Σ𝑗 𝑀𝑉𝑗
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 ESTIMATING THE COST OF CAPITAL

A portfolio like the market portfolio where each security is held in proportion to its market capitalization =
= value-weighted portfolio = passive portfolio, because very little trading is required to maintain it (in
cases the number of shares outstanding of some security changes)
A market index, e.g., S&P500, reports the value of a particular portfolio of securities.
Many mutual fund companies offer funds called index funds that invest in market indices’ portfolios.
• Exchange-traded fund (ETF) = a security that trades directly on an exchange like a stock, but represents
ownership in portfolio of stocks. E.g., Vanguard’s Total Stock Market ETF.
• By investing in an index or an ETF, an individual with a small amount to invest can achieve the benefits of
broad diversification.
• Usually, practitioners use S&P500 as the market portfolio in CAPM.

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 ESTIMATING THE COST OF CAPITAL

The Market Risk Premium: E[𝑅𝑀𝑘𝑡 ] − 𝑟𝑓

Usually, 𝑟𝑓 is determined using the yields of the US Treasury securities or rates from the highest quality corporate
bonds.
One way to estimate E[𝑅𝑀𝑘𝑡 ] − 𝑟𝑓 is to use the historical average excess return of the market over the risk-free
interest rate.
But this can be problematic because standard errors can still be large even after decades of data (e.g., data from
1926, the 95% confidence interval for the excess return is +/- 4.3%), and because they are backward looking.
Question of how many years of data to use, e.g., 1 year or 10 years, etc. Trade-off as the more data the better, but
the older the data the less relevant probably for today and the future.

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Beta estimation: Usually we estimate beta based on historical data on stock’s sensitivity. It may make sense
because beta remains relatively stable over time for most firms.
Beta corresponds to the slope of the “best-fitting” line when regressing the security’s excess returns on the
market excess returns. We can use linear regression:
(𝑅𝑖 − 𝑟𝑓 ) = α𝑖 + β𝑖 (𝑅𝑀𝑘𝑡 − 𝑟𝑓 ) + ε𝑖

α𝑖 = the constant term, the stock’s alpha, measures the historical performance of the security relative to the
expected return predicted by the security market line = the distance above or below the security market line = a
risk-adjusted measure of a stock’s historical performance.
 According to CAPM, α𝑖 = 0 or at least not significantly different from zero.

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The Debt Cost of Capital = the cost of capital a firm must pay on its debt.
What expected return is required by a firm’s creditors?

To estimate the firm’s equity cost of capital we can use the CAPM (based on historical risk data). Given that a
project is not itself a publicly traded security, we cannot apply this.
 Instead, to estimate a project’s beta is to identify comparable firms in the same line of business as the
project we want to undertake.

Case 1: All-equity comparables

An all-equity financed firm (= no debt) in a single line of business that is comparable to the project.
• Because the firm is all-equity, holding the firm’s stock is equivalent to owning the portfolio of its underlying
assets.
• Thus, if the firm’s average investment has similar market risk to our project, then we can use the comparable
firm’s equity beta and cost of capital as estimates for beta and the cost of capital of the project.

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Case 2: Levered firms as comparables

If the firm has debt, the cash flows are used to pay both equity and debt holders.
• The returns of the firm’s equity alone are not representative of the underlying assets; because of leverage, the
equity may be riskier.
• Thus, the beta of a firm’s levered equity is not a good estimate of the beta of its assets and of our project.
 We recreate a claim of a firm’s assets by holding both its debt and equity simultaneously (the firm’s
cash flows will be used to pay either equity- or debt-holders)
Debt + Equity = Assets (identification of a levered firm whose assets have comparable market risk to
our project)
 The return of the firm’s assets is thus the same as the return of a portfolio of the firm’s debt and
equity combined.

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Case 3: The asset (or unlevered) cost of capital

Reminder: The expected return of a portfolio is equal to the weighted average of the expected returns of the
securities in the portfolio. Thus:

A firm’s Asset Cost of Capital =

= (Fraction of Firm Value Financed by Equity)*(Equity Cost of Capital) +
(Fraction of Firm Value Financed by Debt)*(Debt Cost of Capital) =
= the Weighted Average of the Firm’s Equity and Debt Costs of Capital =
𝐸 𝐷
𝑟𝑈 = 𝑟𝐸 + 𝑟
𝐸+𝐷 𝐸+𝐷 𝐷

Where 𝑟𝐸 and 𝑟𝐷 are the equity and debt costs of capital.

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Asset Beta = The weighted average of the components’ betas, similar to having securities in a portfolio
𝐸 𝐷
β𝑈 = β + β
𝐸+𝐷 𝐸 𝐸+𝐷 𝐷

Cash and Net Debt:

Sometimes firms maintain large cash reserves (in excess of their operating needs) = a risk-free asset on the firm’s
balance sheet reducing the average risk of the firm’s assets.
If we are interested in the risk of the firm’s underlying business operations separate from its cash holdings = the
risk of its enterprise value = combined market value of E + D – any excess cash:
 We can measure the leverage of the firm in terms of its net debt:

Net Debt = Debt – Excess Cash and Short-Term Investments

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Industry asset betas

Since we can adjust for the leverage of different firms to determine their asset betas, we may combine estimates
of asset betas for multiple firms in the same segment or industry.
 Businesses that are less sensitive to market and economic conditions tend to have lower asset betas
than the more cyclical industries.

• Industry beta estimates can be sensitive to outliers (consider eliminating outlying values)

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Differences in project risk
Firm asset betas reflect the market risk of the average project in a firm. But projects can be more or less sensitive
to market risk. How a given project can compare with the average project?
Example: 3M has a health care division and a computer display-&-graphics division. These divisions are likely to
have very different market risks. See the difference in market betas of these two industries.
3M’s own asset beta will represent the average of these industries; not a good risk measure of a project in either.
• Instead, evaluate projects based on asset betas of firms that concentrate in a similar line of business
 Thus, for multi-divisional firms, identifying firms of single-industry comparables for each
division will help estimating appropriate divisional costs of capital.
• The characteristics of the project itself also plays a role. E.g., for an IT company, a building lease project
will have different risk from a typical software project, and should use different cost of capital.
• Also, look at the project’s degree of operating leverage = relative proportion of fixed versus variable costs;
higher proportion of fixed costs likely to increase the sensitivity of the project’s cash flows to market risk and
raise the project’s beta. Thus, assign higher cost of capital.

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How may the project’s cost of capital change if the firm uses leverage (debt) to finance the project?
Elements to consider:
Perfect capital markets = No taxes, transaction costs or other frictions.
Under such conditions, the choice of financing does not affect the cost of capital or NPV of a project, which are
determined solely by its free cash flows.
Taxes: If the firm pays interest rate r on its debt, then once the tax deduction is accounted for, the net cost to the
firm is given by:
Effective after-tax interest rate = r(1 – τ𝐶 ) τ𝐶 = the firm’s corporate tax rate

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How may the project’s cost of capital change if the firm uses leverage (debt) to finance the project?
Elements to consider (2):
Weighted Average Cost of Capital (WACC):
When the firm uses debt to finance its projects, it benefits from the interest tax deduction. One way of including
this benefit when calculating the NPV is by using the firm’s effective after-tax cost of capital = WACC.
𝐸 𝐷
𝑟𝑊𝐴𝐶𝐶 = 𝑟𝐸 + 𝑟 (1 − τ𝐶 )
𝐸+𝐷 𝐸+𝐷 𝐷

Comparing the unlevered cost of capital 𝑟𝑈 with 𝑟𝑊𝐴𝐶𝐶 , the first is based on the firm’s pre-tax cost of debt,
whereas the second is based on the after-tax cost of debt.
𝑟𝑈 = “pre-tax WACC” = expected return investors will earn holding the firm’s assets. In a world with taxes, it can
be used to evaluate an All-Equity financed project with the same risk as the firm.

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Weighted Average Cost of Capital (WACC) (2):

𝑟𝑊𝐴𝐶𝐶 = effective after-tax cost of capital. Because interest expense is tax deductible, the WACC is less than the
expected return of the firm’s assets. In a world with taxes, the WACC can be used to evaluate a project with the
same risk and the same financing as the firm itself.
𝐷
𝑟𝑊𝐴𝐶𝐶 = 𝑟𝑈 − τ 𝑟
𝐸+𝐷 𝐶 𝐷

Which shows that WACC is equal to the unlevered cost of capital less the tax savings associated with debt.

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Example:
Market capitalization $100 M, outstanding debt $25 M, equity cost of capital 10%, debt cost of capital is 6%.
What is the asset (unlevered) cost of capital?
𝐸 𝐷 100 25
𝑟𝑈 = 𝑟 + 𝑟 = 10% + 6% = 9.2%
𝐸+𝐷 𝐸 𝐸+𝐷 𝐷 100 + 25 100 + 25

If corporate tax rate is 40%, what is the WACC?

𝐷 25
𝑟𝑊𝐴𝐶𝐶 = 𝑟𝑈 − τ 𝑟 = 9.2% − 40% 6% = 8.72%
𝐸+𝐷 𝐶 𝐷 100 + 25

We can use this WACC to evaluate projects with the same risk and the same mix of E and D
financing.

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Concluding notes

• Avoid mistake of using a single cost of capital for multi-divisional firms.

Different businesses (segments, industries) have different market risks. If the same cost of capital is used for all
investment opportunities, riskier projects will be discounted at a too low a cost of capital making negative NPV
projects to look positive, and vice versa (= less risky projects to be discounted at a too high cost of capital)
• Some benefits of using CAPM:
o It is practical and straightforward to implement.
o It imposes discipline to managers to identify the cost of capital, and making the capital budgeting process less subject to
managerial manipulation (i.e., setting costs of capital without clear justification).
o It makes managers to think about risk in the “correct” way = Not think about diversifiable risk, which shareholders can
eliminate through own portfolio diversification, but focus on and prepare to compensate investors for the market risk in
their decisions.

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