1

Lecture 12
Risk, Return and Capital Budgeting

 Reading
 Brealey, Myers, and Marcus, Chapter 12
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Topics Covered
 Measuring Market Risk
➔ Beta (β)
 Risk and Return
➔ CAPM (Capital Asset Pricing Model） =
 Capital Budgeting and Project Risk
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Measuring Market Risk

 Market Portfolio Fit E
➔ Portfolio of all assets in the economy.

➔ In practice a broad stock market index is used to represent the

market.
• S&P 500, TAIEX, FTS100, DAX
 Beta (β)
➔ Systematic risk ! ENPE

➔ Market risk!

➔ Sensitivity of a stock’s return to the return on the market portfolio.

➔ Measure how the stock return respond to market move

LE
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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.
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Measuring Market Risk

Example - continued

Month Market Ret urn % Turbo Return %

1 +1 + 0.8
2 +1 + 1.8
3 +1 - 0.2
4 -1 - 1.8
5 -1 + 0.2
6 -1 - 0.8
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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.

1 .6
 = = 0 .8
2
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Measuring Market Risk

 Systematic risk for security i , βi

Lov (ri, m)
Bi =
Gm

 The higher the beta the higher the systematic risk!!

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Measuring Market Risk

 Covariance -
➔ A measure of the extent to which the returns
tend to vary with each other

S RE
 Cov.(r1,r2)=  P( s)[( r1 − E (r1 ))( r2 − E (r2 ))]
s =1
RE
**Pl-u
F S
=  [( r1, s − r1 )( r2, s − r2 )]
-
>0
w
s =1
Mit F
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Measuring Market Risk

 What is the systematic risk for the market portfolio?
2

=
Om

Cov( rm , rm )
m =
 2
m

 βm= ? 110 .

+ A :
1 .
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Measuring Market Risk

 What is the systematic risk for risk free asset i?

Cov( ri , rm )
i =
 2
m
 Bi =
0 E
Month Market Ret urn % T - bill Return %
1 +1 + 0.1
2 +1 + 0.1
3 +1 + 0.1
4 -1 + 0.1
5 -1 + 0.1
6 -1 + 0.1
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Measuring Market Risk

Example - continued
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Stock Betas

X >
-

T
Y

β
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Stock Betas

β
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Stock Betas

味全報酬率的市場模型:1990-1994
0.4
0.3
0.2
味
全 0.1

β 報
酬
0
-0.1
味全 = 0.0025+0.8292市場
率 -0.2
-0.3
-0.4
-0.4 -0.3 -0.2 -0.1 0 0.1 0.2 0.3 0.4 0.5

市場報酬率
15 Stock Betas for Common Stocks
(January 2015 – December 2019
 https://www.stock-analysis-on.net/NASDAQ/Company/Starbucks-Corp/DCF/CAPM#Systematic-
Risk-Estimation

Ticker Company Beta • What factors

X U.S. Steel 3.03 contribute to the
MRO Marathon Oil 2.35 variation in these
AM ZN Amazon 1.51 betas?
BM IBM 1.33 Variance =
i
BA Boeing 1.19
B Epi
:

F Ford 1.09
UNP Union Pacific 1.07
GOOG Google/Alphabet 1.01
DIS Disney 1.00
XOM ExxonMobil 1.00
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Stock Betas
•What is the beta for a portfolio which includes
more than two stocks?
• 60% in Amazon and 40% in IBM
• what is the systematic risk of this portfolio?
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Portfolio Betas
 Diversification decreases variability from unique risk, but not
from market risk. FE-SE En
 The beta of your portfolio will be an average of the betas of
the securities in the portfolio. Fin :
EBADOE
 If you owned all of the S&P Composite Index stocks, you
would have an average beta of 1.0
 Beta of a portfolio:
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Portfolio Betas
FEAYD .
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Portfolio Betas
 Example: $1,000 investment from Jan. 2003 to Dec. 2007
➔ 60% in Amazon and 40% in IBM

➔ Beta of Amazon is 2.39 and beta of IBM is 1.13

➔ what is the systematic risk of this portfolio?

➔ βp = ?

96x439 + 0 .
4x113 11886.
:
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Risk and Return

 What is the relationship between risk and return?
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Measuring Market Risk

 Market Risk Premium PEIH
➔ Risk premium of market portfolio.

➔ Difference between (expected) market return and return on risk-free assets

(Treasury bills).
• E(rm) - rf - (Et market risk AEG

• E(rm): Expected return of market portfolio

 The relationship between risk and return:
➔ Assume market portfolio return is 12% and risk free rate of return is 4%

(B =
1) (B =
0)
* B =
/
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Measuring Market Risk

Market
Portfolio
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Market Risk Premium: Example

Example:
Let, market risk premium = 8%
rf = 4% Market Portfolio
(market return =
rm = 12% 12%)

Market Risk Premium = 8%

rf = 4%
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Measuring Market Risk

 Capital Asset Pricing Model (CAPM) Fi
➔ 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.

Vi -Ut Bi
=

(Elrm) - V+ (
B 1
Expected market risk premium = E(rm ) - rf
=

Risk premium on any asset i = ri - rf

PE .
Expected Return on any asset i = ri = rf +  i (E(r m ) - rf )
Phig
EE EP
ELTAY Pla)
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Measuring Market Risk

Example
The return on the stock market is 10% and he risk free rate of return is
3%. What is the risk premium for a stock that has a beta of 0.5? What is
the expected return of the stock?

Market risk premium = rm − rf = .10 − .03 = .07

Risk premium on any asset = β(rm − rf)= .5 × .07 = .035
Expected return = rf + β(rm − rf) = .03 + .035 = .065
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Measuring Market Risk

Example – (continued)
Graph the stock as well as a stock with a beta of .2 and the market
portfolio
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Capital Asset Pricing Model

CAPM
Ecri) = Ut + Bi (E(rm) -

r+ (

The CAPM was introduced by Jack Treynor (1961, 1962), William F. Sharpe (1964),
John Lintner (1965a,b) and Jan Mossin (1966) independently, building on the earlier
work of Harry Markowitz on diversification and modern portfolio theory. Sharpe,
Markowitz and Merton Miller jointly received the 1990 Nobel Memorial Prize in
Economics for this contribution to the field of financial economics.
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Capital Asset Pricing Model

 The expected rate of return demanded by investors depend on two things:
➔ Compensation for the time value of money (the risk-free rate)

➔ A risk premium: depends on beta and the market risk premium

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Measuring Market Risk

 Security Market Line
➔ The graphic representation of the CAPM.
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Security Market Line

 In reality, we use historical data as proxy for expected data!!
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Security Market Line

Return

SML

rf
1.0 BETA

SML Equation = rf + βi ( rm - rf )
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Security Market Line

 Does CAPM really work?
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Testing the CAPM

Beta vs. Average Risk Premium
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Testing the CAPM

T* B boko-market ratio Text)
S Return vs. Book-to-Market
+X9)
**** --
racio

49
-
book-to-market
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Stock Expected Returns

Expected Expected
Return Return
Ticker Company Beta (%) Ticker Company Beta (%)
X U.S. Steel 3.03 22.2 I NT C Intel 0.91 7.3

E (r )
MR O Marathon Oil 2.35 17.4 PFE Pfizer 0.65 5.6
A MZ N Amazon 1.51 11.5 PCG Pacific Gas &
0.55 4.9
Electric
I BM I BM 1.33 10.3
S BUX Starbucks 0.51 4.5
BA Boeing 1.19 9.3
MC D McDonald’s 0.45 4.1
F Ford 1.09 8.6
CPB Campbell Soup 0.43 4.0
UNP Union Pacific 1.07 8.5 it
G O OG Google/Alphabet 1.01 8.1
KO Coca-Cola 0.43 4.0
B = 0
W MT Walmart 0.35 3.5
DI S Disney 1.00 8.0
XO M ExxonMobil 1.00 8.0
NE M Newmont Mining −0.01 0.9 ↑
Average
Bl ank

0.99 7.94 ri = U +.
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Testing the CAPM

 CAPM seems to work, not too bad!
 How could we apply CAPM for capital budgeting?
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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
 Company cost of capital
➔ Opportunity cost of capital for investment in the firm as a whole

➔ The company cost of capital is the appropriate discount rate for an

average-risk investment project undertaken by the firm
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Capital Budgeting & Project Risk

 Shareholders need the company to earn at least the opportunity
cost of capital on its investments.
➔ Estimate company risk (systematic risk!)

➔ Decide the risk free rate

➔ Apply CAPM to measure required rate of return (expected

return)
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Capital Budgeting & Project Risk

 risk of the company
➔ When new products/projects do not have the same risk as its existing

business:
• risk of the new product/project *

#P
• 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 on the risk
of the company.
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Capital Budgeting & Project Risk

 Suppose there is one project with 1.25 beta, the current expected return
is 15%, is this project attractive?
 Risk free rate is: 3%, market rate: 11%
 What is the expected return by CAPM?
3 % + 125x(11 % -
3
%)
=
13% < 15 %
>
-
attractive
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Capital Budgeting & Project Risk

E(r)
SML
15%
Rm=11%

rf=3%
ß
1.0 1.25
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Capital Budgeting & Project Risk

 Security market line provides a standard for project acceptance.
➔ If the project’s expected return lies above the SML, then it is higher

than investors could expect to earn by investing their funds in the

capital market and the project is an attractive investment
opportunity.
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Capital Budgeting & Project Risk

 Example
F
 Based on the CAPM, ABC Company has a cost of capital of 17%. [4 +
.

14% 4 %. (market risk premium)

.
risk 1.3(10)]. Expected market return is 14% and risk free rate is 4%. A
system
caverage b) breakdown of the company’s investment projects is listed below. When

evaluating a new dog food production investment, what cost of capital

should be used?

➔ 1/3 Nuclear Parts Mfr. β=2.0

➔ 1/3 Computer Hard Drive Mfr. β=1.3
➔ 1/3 Dog Food Production β=0.6
➔ AVG. β of assets
-1 3
1
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Capital Budgeting & Project Risk

 Example
 When evaluating a new dog food production investment, which
cost of capital should be used?
dogtod B, Tt
~

r= +% + 06 (14% 4 % ) 10 %.
-

 10% cost of capital reflects the opportunity cost of capital on

an investment given the unique risk of the project.