L5 - Capital Markets, Risk Return

Corporate Finance
BNKG2002
Lecture 5
Capital Market Theory
Risk & return
6-1
9
Chapter 9
CAPITAL MARKET THEORY: AN OVERVIEW
1-2
Chapter Outline
 Returns
 Holding-Period Returns
 Return Statistics
 Average Stock Returns and Risk-Free Returns
 Risk Statistics
 Summary and Conclusions
9.1 Returns
 Dollar Returns
 the sum of the cash received Dividends
and the change in value of the
asset, in dollars. Ending
market value
Time 0 1
• Percentage Returns
– the sum of the cash received and the
change in value of the asset divided by
Initial the original investment.
investment 9-4
9.1 Returns
Dollar Return = Dividend + Change in Market Value
dollar return
percentage return =
beginning market value
dividend + change in market value

=
beginning market value
= dividend yield + capital gains yield

9.1 Returns: Example
 Suppose you bought 100 shares of Wal-Mart (WMT) one
year ago today at $25. Over the last year, you received
$20 in dividends (= 20 cents per share × 100 shares). At
the end of the year, the stock sells for $30. How did you
do?
 Quite well. You invested $25 × 100 = $2,500. At the end
of the year, you have stock worth $3,000 and cash
dividends of $20. Your dollar gain was $520 = $20 +
($3,000 – $2,500).
$520
 Your percentage gain for the year is 20.8% = $2,500
9-6
9.1 Returns: Example
Dollar Return:
$520 gain $20
$3,000
Time 0 1
Percentage Return:
$520
-$2,500 20.8% =
$2,500
9-7
9.2 Holding-Period Returns
 The holding period return is the return that an
investor would get when holding an investment
over a period of n years, when the return
during year i is given as ri:
holding period return 
 (1  r1 )  (1  r2 )    (1  rn )  1
9-8
Holding Period Return: Example
 Suppose your investment provides the following returns over a
four-year period:
Year Return Your holding period return 

1 10%  (1  r1 )  (1  r2 )  (1  r3 )  (1  r4 )  1
2 -5%
3 20%  (1.10)  (.95)  (1.20)  (1.15)  1
4 15%  .4421  44.21%
9-9
 An investor who held this investment would have actually realized
an annual return of 9.58%:
Year Return Geometric average return 

1 10% (1  rg ) 4  (1  r1 )  (1  r2 )  (1  r3 )  (1  r4 )
2 -5%
3 20% rg  4 (1.10)  (.95)  (1.20)  (1.15)  1
4 15%  .095844  9.58%
So, our investor made 9.58% on his money for four
years, realizing a holding period return of 44.21%
1.4421  (1.095844) 4
9-10
 Note that the geometric average is not the same thing as the
arithmetic average:
Year Return
r1  r2  r3  r4
1 10% Arithmetic average return 
2 -5%
4
3 20% 10%  5%  20%  15%
  10%
4 15% 4
9-11
Holding Period Returns
A famous set of studies dealing with the rates of returns on
common stocks, bonds, and Treasury bills was conducted by
Roger Ibbotson and Rex Sinquefield.
 They present year-by-year historical rates of return starting in
1926 for the following five important types of financial instruments
in the United States:
 Large-Company Common Stocks
 Small-company Common Stocks
 Long-Term Corporate Bonds
 Long-Term U.S. Government Bonds
 U.S. Treasury Bills
9-12
Wealth Indexes of
Investments in the
U.S. Capital
Markets
(Year-End 1925 = $1.00)
6-13
9.3 Return Statistics
 Thehistory of capital market returns can be summarized by
describing the
 average return
( R1    RT )
R
T
 the standard deviation of those returns
( R1  R ) 2  ( R2  R ) 2   ( RT  R ) 2
SD  VAR 
T 1
 the frequency distribution of the returns.
9-14
Historical
Returns,
1926-2011
9-15
9.4 Average Stock Returns
and Risk-Free Returns
 The Risk Premium is the additional return (over and above
the risk-free rate) resulting from bearing risk.
 One of the most significant observations of stock market
data is this long-run excess of stock return over the risk-free
return.
 The average excess return from small company common stocks for
the period 1926 through 2011 was 12.9% = 16.5% – 3.6%
 The average excess return from large company common stocks for
the period 1926 through 2011 was 8.2% = 11.8% – 3.6%
 The average excess return from long-term corporate bonds for the
period 1926 through 2011 was 2.8% = 6.4% – 3.6%
9-16
Risk Premia
 Suppose that The Wall Street Journal announced that the current
rate for on-year Treasury bills is 5%.
 What is the expected return on the market of small-company
stocks?
 Recall that the average excess return from small company
common stocks for the period 1926 through 2011 was 12.9%
 Given a risk-free rate of 5%, we have an expected return on the
market of small-company stocks of 17.9% = 12.9% + 5%
9-17
The Risk-Return Tradeoff
9-18
Rates of Return 1926-2002
60
40
20
-20
Common Stocks
Long T-Bonds
-40
T-Bills
-60 26 30 35 40 45 50 55 60 65 70 75 80 85 90 95 2000
Source: © Stocks, Bonds, Bills, and Inflation 2000 Yearbook™, Ibbotson Associates, Inc., Chicago (annually updates work by
Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved.
9-19
Risk Premiums
 Rate of return on T-bills is
essentially risk-free.
 Investing in stocks is risky, but
there are compensations.
 The difference between the return
on T-bills and stocks is the risk
premium for investing in stocks.
 An old saying on Wall Street is
“You can either sleep well or eat
well.” Stock Market Risk Premiums for 17 Countries:
1900–2010
9-20
Stock Market Volatility
The volatility of stocks is not constant from year to year.
60
50
40
30
20
10
2 6 35 40 45 50 55 60 65 70 75 80 85 90 95 98
19 19 19 19 19 19 19 19 19 19 19 19 19 19 19
Source: © Stocks, Bonds, Bills, and Inflation 2000 Yearbook™, Ibbotson Associates, Inc., Chicago (annually updates work by
Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved. 9-21
9.5 Risk Statistics
 There is no universally agreed-upon definition of risk.
 The measures of risk that we discuss are variance and standard deviation.
 The standard deviation is the standard statistical measure of the spread of a sample, and it will
be the measure we use most of this time.
 Its interpretation is facilitated by a discussion of the normal distribution.
9-22
Normal Distribution
A large enough sample drawn from a normal
distribution looks like a bell-shaped curve.
Probability
The probability that a yearly

return will fall within 20.1
percent of the mean of 13.3
percent will be
approximately 2/3.
– 3s – 2s – 1s 0 + 1s + 2s + 3s
– 49.3% – 28.8% – 8.3% 12.2% 32.7% 53.2% 73.7%
Return on
68.26% large company common
stocks
95.44%
99.74% 9-23
Normal Distribution
 The 20.1-percent standard deviation we found for

stock returns of small companies from 1926 through
2011 can now be interpreted in the following way: if
stock returns are approximately normally
distributed, the probability that a yearly return will
fall within 32.5 percent of the mean of 16.5 percent
will be approximately 2/3.
9-24
Normal Distribution
S&P 500 Return Frequencies
16
16
Normal
approximation 14
Mean = 12.8% 12 12
12
Return frequency
Std. Dev. = 20.4% 11
9 10
5 6
4
2 2
1 1 1 2
0 0
0
-58% -48% -38% -28% -18% -8% 2% 12% 22% 32% 42% 52% 62%
Annual returns
Source: © Stocks, Bonds, Bills, and Inflation 2002 Yearbook™, Ibbotson Associates, Inc., Chicago
(annually updates work by Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved.
9-25
9.6 Summary and Conclusions
 This chapter presents returns for four asset classes:
 Large Company Stocks
 Small Company Stocks
 Long-Term Government Bonds
 Treasury Bills
 Stocks have outperformed bonds over most of the twentieth century, although stocks
have also exhibited more risk.
 The stocks of small companies have outperformed the stocks of small companies
over most of the twentieth century, again with more risk.
 The statistical measures in this chapter are necessary building blocks for the material
of the next three chapters.
9-26
10
Chapter 10
THE CAPITAL ASSET PRICING MODEL (CAPM)
1-27
Chapter Outline
10.1 Individual Securities
10.2 Expected Return, Variance, and Covariance
10.3 The Return and Risk for Portfolios
10.4 The Efficient Set for Two Assets
10.5 The Efficient Set for Many Securities
10.6 Diversification: An Example
10.7 Riskless Borrowing and Lending
10.8 Market Equilibrium
10.9 Relationship between Risk and Expected Return (CAPM)
10-28
10.1 Individual Securities
 The characteristics of individual securities that are of interest are the:
 Expected Return
 Variance and Standard Deviation
 Covariance and Correlation
10-29
10.2 Expected Return, Variance,
and Covariance
Rate of Return
Scenario Probability Stock fund Bond fund
Recession 33.3% -7% 17%
Normal 33.3% 12% 7%
Boom 33.3% 28% -3%
Consider the following two risky asset world. There is a 1/3

chance of each state of the economy and the only assets are a
stock fund and a bond fund.
10-30
and Covariance
Stock fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%
10-31
and Covariance
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
E (rS ) = 1 ´( -7%) + 1 ´(12%) + 1 ´(28%)

3 3 3
E (rS ) = 11% 10-32
and Covariance
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
E (rB ) = 1 ´(17%) + 1 ´(7%) + 1 ´( -3%)

3 3 3
E (rB ) = 7% 10-33
and Covariance
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
(11% 7%) = 3.24%

- - 2
10-34
and Covariance
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
(11% 12%) = .01%

- 2
10-35
and Covariance
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
(11% 28%) = 2.89%

- 2
10-36
and Covariance
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
1
2.05% = (3.24% + 0.01% + 2.89%)
3
10-37
and Covariance
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
14.3% = 0.0205
10-38
10.3 The Return and Risk
for Portfolios
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
Note that stocks have a higher expected return than bonds and
higher risk. Let us turn now to the risk-return tradeoff of a portfolio
that is 50% invested in bonds and 50% invested in stocks.
10-39
10.3 The Return and Risk for
Portfolios
Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%
Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%
The rate of return on the portfolio is a weighted average of the

returns on the stocks and bonds in the portfolio:
rP = wB rB + wS rS
5%  50%  (7%)  50%  (17%)
10-40
Portfolios
Rate of Return
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Variance 0.0205 0.0067 0.0010

rP = wB rB + wS rS
9.5% = 50% ´(12%) + 50% ´(7%)

10-41
Portfolios
Rate of Return
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Variance 0.0205 0.0067 0.0010

rP = wB rB + wS rS
12.5% = 50% ´(28%) + 50% ´( -3%)
10-42
Portfolios
Rate of Return
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Variance 0.0205 0.0067 0.0010
The expected rate of return on the portfolio is a weighted average

of the expected returns on the securities in the portfolio.
E (rP ) = wB E (rB ) + wS E (rS )
9% = 50% ´(11%) + 50% ´(7%)
10-43
Portfolios
Rate of Return
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Variance 0.0205 0.0067 0.0010
The variance of the rate of return on the two risky assets portfolio is
σ P = (wB σ B ) + (wS σS ) + 2(wB σ B )(wS σS )ρBS
2 2 2
where BS is the correlation coefficient between the returns on the

stock and bond funds. 10-44
Portfolios
Rate of Return
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Variance 0.0205 0.0067 0.0010
Observe the decrease in risk that diversification offers.

An equally weighted portfolio (50% in stocks and 50% in bonds)
has less risk than stocks or bonds held in isolation.
10-45
10.4 The Efficient Set for Two
Assets
% in stocks Risk Return
0% 8.2% 7.0%
5% 7.0% 7.2%
Portfolo Risk and Return Combinations
10% 5.9% 7.4% 12.0%
15% 4.8% 7.6%
Portfolio Return
11.0%
20% 3.7% 7.8%
10.0% 100%
25% 2.6% 8.0%
9.0% stocks
30% 1.4% 8.2%
8.0%
35% 0.4% 8.4%
7.0%
40% 0.9% 8.6% 100%
6.0%
45% 2.0% 8.8% bonds
50.00% 3.08% 9.00% 5.0%
55% 4.2% 9.2% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
60% 5.3% 9.4%
Portfolio Risk (standard deviation)
65% 6.4% 9.6%
70% 7.6% 9.8%
75% 8.7% 10.0% We can consider other
80%
85%
9.8%
10.9%
10.2%
10.4%
portfolio weights besides
90% 12.1% 10.6% 50% in stocks and 50% in
95% 13.2% 10.8%
100% 14.3% 11.0%
bonds …
10-46
Assets
% in stocks Risk Return
0%
0% 8.2%
8.2% 7.0%
7.0%
5%
5% 7.0%
7.0% 7.2%
7.2%
Portfolo Risk and Return Combinations
10%
10% 5.9%
5.9% 7.4%
7.4% 12.0%
15%
15% 4.8%
4.8% 7.6%
7.6%
Portfolio Return
11.0%
20%
20% 3.7%
3.7% 7.8%
7.8%
10.0% 100%
25%
25% 2.6%
2.6% 8.0%
8.0%
9.0% stocks
30%
30% 1.4%
1.4% 8.2%
8.2%
8.0%
35%
35% 0.4%
0.4% 8.4%
8.4%
7.0%
40%
40% 0.9%
0.9% 8.6%
8.6% 100%
45% 2.0% 8.8% 6.0%
45% 2.0% 8.8% bonds
50%
50% 3.1%
3.1% 9.0%
9.0% 5.0%
55%
55% 4.2%
4.2% 9.2%
9.2% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
60%
60% 5.3%
5.3% 9.4%
9.4%
Portfolio Risk (standard deviation)
65%
65% 6.4%
6.4% 9.6%
9.6%
70%
70% 7.6%
7.6% 9.8%
9.8%
75%
75% 8.7%
8.7% 10.0%
10.0% We can consider other
80%
80%
85%
85%
9.8%
9.8%
10.9%
10.9%
10.2%
10.2%
10.4%
10.4%
portfolio weights besides
90%
90% 12.1%
12.1% 10.6%
10.6% 50% in stocks and 50% in
95%
95% 13.2%
13.2% 10.8%
10.8%
100%
100% 14.3%
14.3% 11.0%
11.0%
bonds …
10-47
Assets
% in stocks Risk Return Portfolo Risk and Return Combinations
0% 8.2% 7.0%
5% 7.0% 7.2% 12.0%
Portfolio Return
10% 5.9% 7.4% 11.0%
15% 4.8% 7.6% 10.0%
20% 3.7% 7.8% 9.0% 100%
25% 2.6% 8.0% 8.0% stocks
30% 1.4% 8.2% 7.0%
35% 0.4% 8.4% 6.0%
40% 0.9% 8.6% 100%
5.0%
45% 2.0% 8.8% bonds
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
50% 3.1% 9.0%
55% 4.2% 9.2% Portfolio Risk (standard deviation)
60% 5.3% 9.4%
65% 6.4% 9.6% Note that some portfolios are
70% 7.6% 9.8%
75% 8.7% 10.0% “better” than others. They have
80% 9.8% 10.2% higher returns for the same level of
85% 10.9% 10.4%
90% 12.1% 10.6% risk or less.These compromise the
95% 13.2% 10.8%
100% 14.3% 11.0% efficient frontier.
10-48
Two-Security Portfolios with Various
Correlations
return
100%
 = -1.0 stocks
 = 1.0
100%
 = 0.2
bonds

 Relationship depends on correlation coefficient
-1.0 < r < +1.0
 If r = +1.0, no risk reduction is possible
 If r = –1.0, complete risk reduction is possible

10-49
10-50
Portfolio Risk as a Function of the Number of

Stocks
in the Portfolio
In a large portfolio the variance terms are effectively
 diversified away, but the covariance terms are not.
Diversifiable Risk;
Nonsystematic Risk;
Firm Specific Risk;
Unique Risk
Portfolio risk
Nondiversifiable risk;
Systematic Risk;
Market Risk
Thus diversification can eliminate some, n
but not all of the risk of individual securities.
10.5 The Efficient Set for Many
Securities
return Individual Assets
P
Consider a world with many risky assets; we can still
identify the opportunity set of risk-return
combinations of various portfolios.
10-51
Securities
return
minimum
variance
portfolio
Individual Assets
Given the opportunity set we can identify the minimum variance
portfolio.
P
10-52
Securities
return
nt ier
ent fro
c i
effi
minimum
variance
portfolio
Individual Assets
P
The section of the opportunity set above the minimum
variance portfolio is the efficient frontier.
10-53
Optimal Risky Portfolio with a Risk-Free
Asset
return
100%
stocks
rf
In addition to stocks and bonds, consider
100% a world that also has risk-
free securities like T-bills bonds
10-54
10.7 Riskless Borrowing and
Lending
return
CM 100%
stocks
Balanced
fund
rf
Now investors can allocate their money
100% across the T-bills and a
balanced mutual fund bonds
10-55
10.7 Riskless Borrowing and
Lending
return
L
CM efficient frontier
rf asset available and the efficient

With a risk-free
frontier identified, we choose the capital allocation
line with the steepest slope P
10-56
10.8 Market Equilibrium
return
L
rf
P
With the capital allocation line identified, all investors choose a point along
the line—some combination of the risk-free asset and the market
portfolio M. In a world with homogeneous expectations, M is the same
for all investors.
10-57
The Separation Property
return
L
rf Property states that the market portfolio, M, is

The Separation
the same for all investors—they can separate their risk
aversion from their choice of the market portfolio.
 P
10-58
return
L
rf
P
Investor risk aversion is revealed in their choice of where to
stay along the capital allocation line—not in their choice of
the line.
10-59
Market Equilibrium
return
CM 100%
stocks
Balanced
fund
rf
100%
bonds

Just where the investor chooses along the Capital Asset Line
depends on his risk tolerance. The big point though is that all
investors have the same CML.
10-60
Market Equilibrium
return
CM 100%
stocks
Optimal
Risky
Portfolio
rf
All investors have the same CML because they all
100%
bonds
have the same optimal risky portfolio given the risk-

free rate.
10-61
return
CM 100%
stocks
Optimal
Risky
Portfolio
rf
The separation property implies that portfolio choice can be
100%
separated into two tasks: (1)bonds
determine the optimal risky
portfolio, and (2) selecting a point on the CML.

10-62
Optimal Risky Portfolio with a Risk-Free
Asset
L 0 CML 1
return
CM 100%
stocks
1 First Second Optimal

rf Optimal Risky Portfolio
0 Risky
r Portfolio
By the way, the foptimal risky portfolio
100%
depends on the risk-free rate
as well as the risky assets. bonds
10-63
Definition of Risk When Investors Hold
the Market Portfolio
 Researchers have shown that the best measure of the risk of a security in a large
portfolio is the beta (b)of the security.
 Beta measures the responsiveness of a security to movements in the market
portfolio.
Cov ( Ri , RM )
bi =
s2 ( RM )
10-64
Estimating b with regression
Security Returns
i ne
t i cL
ri s
c te
ara
Ch Slope = bi
Return on
market %
Ri = a i + biRm + ei
10-65
Estimates of b for Selected Stocks
Stock Beta
Bank of America 1.55
Borland International 2.35
Travelers, Inc. 1.65
Du Pont 1.00
Kimberly-Clark Corp. 0.90
Microsoft 1.05
Green Mountain Power 0.55
Homestake Mining 0.20
Oracle, Inc. 0.49
10-66
The Formula for Beta
Cov ( Ri , RM )
bi =
s ( RM )
2
Clearly, your estimate of beta will depend upon your

choice of a proxy for the market portfolio.
10-67
10.9 Relationship between Risk
and Expected Return (CAPM)
Expected Return on the Market:

R M  RF  Market Risk Premium
Expected return on an individual security:
R i  RF  β i  ( R M  RF )
Market Risk Premium

This applies to individual securities held within well-
diversified portfolios. 10-68
Expected Return on an Individual
Security
 This formula is called the Capital Asset Pricing Model (CAPM)
Ri = RF + βi ´( RM - RF )
Expected
Risk- Beta of the Market risk
return on = + ×
free rate security premium
a security
• Assume b = 0, then the expected return is R .

i F
• Assume b = 1, then Ri = RM
i
10-69
Relationship Between Risk & Expected
Return
Expected return
RM
RF
1.0 b
10-70
Relationship Between Risk & Expected
Return
Expected
return
13.5%
3%
1.5 b
β i  1. 5 RF = 3% RM =10%
R i  3%  1.5  (10%  3%)  13.5% 10-71
 This chapter sets forth the principles of modern portfolio theory.
 The expected return and variance on a portfolio of two securities A and B are
given by
E (rP ) = wA E (rA ) + wB E (rB )
σP = (wA σ A ) +(wB σB ) + 2(wB σB )(wA σ A )ρAB

2 2 2
 By varying wA, one can trace out the efficient set of portfolios. We graphed the
efficient set for the two-asset case as a curve, pointing out that the degree of
curvature reflects the diversification effect: the lower the correlation between
the two securities, the greater the diversification.
 The same general shape holds in a world of many assets.
10-72
 The efficient set of risky assets can be combined with
riskless borrowing and lending. In this case, a rational
investor will always choose to hold the portfolio of risky
securities represented by the market portfolio.
return
L
Then with borrowing
or lending, the M
investor selects a point
along the CML.
rf
P
10-73
 The contribution of a security to the risk of a well-diversified
portfolio is proportional to the covariance of the security's
return with the market’s return. This contribution is called the
beta.
Cov( Ri , RM )
bi =
s2 ( RM )
 The CAPM states that the expected return on a security is

positively related to the security’s beta:
10-74
12
Chapter 12
RISK, COST OF CAPITAL, AND CAPITAL BUDGETING
1-75
Chapter Outline
12.1 The Cost of Equity Capital
12.2 Estimation of Beta
12.3 Determinants of Beta
12.4 Extensions of the Basic Model
12.5 Estimating International Paper’s Cost of Capital
12.6 Reducing the Cost of Capital
12-76
What’s the Big Idea?
 Earlierchapters on capital budgeting
focused on the appropriate size and
timing of cash flows.
 This chapter discusses the appropriate
discount rate when cash flows are risky.
12-77
12.1 The Cost of Equity Capital
Shareholder
Firm with invests in
excess cash Pay cash dividend financial
asset
A firm with excess cash can either pay a
dividend or make a capital investment
Shareholder’s
Invest in project Terminal
Value
Because stockholders can reinvest the dividend in risky financial assets,
the expected return on a capital-budgeting project should be at least as
great as the expected return on a financial asset of comparable risk.
12-78
The Cost of Equity
 From the firm’s perspective, the expected return is the Cost of
Equity Capital:
 To estimate a firm’s cost of equity capital, we need to know three

things:
Ri = RF + βi ( RM - RF )
1. The risk-free rate, RF

2. The market risk premium, RM - RF
3. The company beta, β = Cov( Ri , RM ) = σi , M
i 2
Var ( RM ) σM
12-79
Example
 Suppose the stock of Stansfield Enterprises, a

publisher of PowerPoint presentations, has a beta
of 2.5. The firm is 100-percent equity financed.
 Assume a risk-free rate of 5-percent and a market
risk premium of 10-percent.
 What is the appropriate discount rate for an
expansion of this firm?
R  RF  βi ( R M  RF )
R = 5% + 2.5 ´10%
R = 30% 12-80
Example (continued)
Suppose Stansfield Enterprises is evaluating the following
non-mutually exclusive projects. Each costs $100 and lasts
one year.
Project Project b Project’s IRR NPV at
Estimated 30%
Cash Flows
Next Year
A 2.5 $150 50% $15.38
B 2.5 $130 30% $0
C 2.5 $110 10% -$15.38
12-81
Using the SML to Estimate the Risk-
Adjusted Discount Rate for Projects
Good SML
IRR
Project
A
project
30% B
C Bad project
5%
Firm’s risk (beta)
2.5
An all-equity firm should accept a project whose IRR exceeds
the cost of equity capital and reject projects whose IRRs fall
short of the cost of capital.
12-82
12.2 Estimation of Beta: Measuring
Market Risk
Market Portfolio - Portfolio of all assets 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.
12-83
12.2 Estimation of Beta
 Theoretically, the calculation of beta is straightforward:
2
Cov( Ri , RM ) σ
β  i
2
Var ( RM ) σ M
 Problems
1. Betas may vary over time.
2. The sample size may be inadequate.
3. Betas are influenced by changing financial leverage and business risk.
 Solutions
– Problems 1 and 2 (above) can be moderated by more sophisticated statistical techniques.
– Problem 3 can be lessened by adjusting for changes in business and financial risk.
– Look at average beta estimates of comparable firms in the industry.
12-84
Stability of Beta
 Most analysts argue that betas are generally stable for firms
remaining in the same industry.
 That’s not to say that a firm’s beta can’t change.
 Changes in product line
 Changes in technology
 Deregulation
 Changes in financial leverage
12-85
Using an Industry Beta
 It is frequently argued that one can better estimate a
firm’s beta by involving the whole industry.
 If you believe that the operations of the firm are similar to
the operations of the rest of the industry, you should use
the industry beta.
 If you believe that the operations of the firm are
fundamentally different from the operations of the rest of
the industry, you should use the firm’s beta.
 Don’t forget about adjustments for financial leverage.
12-86
12.3 Determinants of Beta
 Business Risk
 Cyclicity
of Revenues
 Operating Leverage
 Financial Risk
 Financial Leverage
12-87
Cyclicality of Revenues
 Highly cyclical stocks have high betas.
 Empirical evidence suggests that retailers and automotive firms
fluctuate with the business cycle.
 Transportation firms and utilities are less dependent upon the
business cycle.
 Note that cyclicality is not the same as variability—stocks with high
standard deviations need not have high betas .
 Movie studios have revenues that are variable, depending upon
whether they produce “hits” or “flops”, but their revenues are not
especially dependent upon the business cycle.
12-88
Operating Leverage
 The degree of operating leverage measures how sensitive
a firm (or project) is to its fixed costs.
 Operating leverage increases as fixed costs rise and
variable costs fall.
 Operating leverage magnifies the effect of cyclicity on
beta.
 The degree of operating leverage is given by:
DOL = D EBIT Sales

×
EBIT D Sales
12-89
Operating Leverage
Total
 EBIT
$ costs
Fixed costs
 Volume
Fixed costs
Volume
Operating leverage increases as fixed costs rise

and variable costs fall.
12-90
Financial Leverage and Beta
 Operating leverage refers to the sensitivity to the firm’s fixed costs
of production.
 Financial leverage is the sensitivity of a firm’s fixed costs of
financing.
 The relationship between the betas of the firm’s debt, equity, and
assets is given by:
bAsset = Debt × bDebt + Equity × bEquity

Debt + Equity Debt + Equity
 Financial leverage always increases the equity beta relative to the
asset beta.
12-91
Financial Leverage and Beta: Example
Consider Grand Sport, Inc., which is currently all-equity and has a
beta of 0.90.
The firm has decided to lever up to a capital structure of 1 part debt to
1 part equity.
Since the firm will remain in the same industry, its asset beta should
remain 0.90.
However, assuming a zero beta for its debt, its equity beta would
become twice as large:
1
bAsset = 0.90 = × bEquity
1+1
bEquity = 2 × 0.90 = 1.80
12-92
12.4 Extensions of the Basic Model
 The Firm versus the Project

 The Cost of Capital with Debt
12-93
The Firm versus the Project
 Any project’s cost of capital depends on the use to
which the capital is being put—not the source.
 Therefore, it depends on the risk of the project and not
the risk of the company.
12-94
Capital Budgeting & Project Risk
Project IRR
SML
The SML can tell us why:
Incorrectly accepted
negative NPV projects
Hurdle RF  β FIRM ( R M  RF )
rate
Incorrectly rejected
rf positive NPV projects
Firm’s risk (beta)
bFIRM
A firm that uses one discount rate for all projects may over time
increase the risk of the firm while decreasing its value.
12-95
Suppose the Conglomerate Company has a cost of capital, based on
the CAPM, of 17%. The risk-free rate is 4%; the market risk
premium is 10% and the firm’s beta is 1.3.
17% = 4% + 1.3 × [14% – 4%]
This is a breakdown of the company’s investment projects:
1/3 Automotive retailer b = 2.0
1/3 Computer Hard Drive Mfr. b = 1.3
1/3 Electric Utility b = 0.6
average b of assets = 1.3

When evaluating a new electrical generation investment,
which cost of capital should be used?
12-96
Project IRR SML
24% Investments in hard

drives or auto retailing
17%
should have higher
10% discount rates.
Project’s risk (b)

0.6 1.3 2.0
r = 4% + 0.6×(14% – 4% ) = 10%
10% reflects the opportunity cost of capital on an investment in
electrical generation, given the unique risk of the project.
12-97
The Cost of Capital with Debt
 The Weighted Average Cost of Capital is given by:
Equity Debt
rWACC = × rEquity + × rDebt ×(1 – TC)
Equity + Debt Equity + Debt
 It is because interest
S expense isBtax-deductible that we multiply
the lastrWACC
term=by (1 – TC)
× rS + × rB ×(1 – TC)
S+B S+B
12-98
12.5 Estimating International
Paper’s Cost of Capital
 First, we estimate the cost of equity and the cost of
debt.
 We estimate an equity beta to estimate the cost of equity.
 We can often estimate the cost of debt by observing the
YTM of the firm’s debt.
 Second, we determine the WACC by weighting
these two costs appropriately.
12-99
12.5 Estimating IP’s Cost of Capital
 The industry average beta is 0.82; the risk free rate
is 8% and the market risk premium is 8.4%.
rS = RF + bi × ( RM – RF)
 Thus the cost of equity capital is
= 3% + 0.82×8.4%
= 9.89%
12-100
12.5 Estimating IP’s Cost of Capital
 The yield on the company’s debt is 8% and the firm is in
the 37% marginal tax rate.
 The debt to value ratio is 32%
S B
rWACC = × rS + × rB ×(1 – TC)
S+B S+B
= 0.68 × 9.89% + 0.32 × 8% × (1 – 0.37)
= 8.34%
8.34 percent is International’s cost of capital. It should be used to discount
any project where one believes that the project’s risk is equal to the risk of
the firm as a whole, and the project has the same leverage as the firm as a
whole. 12-101
12.6 Reducing the Cost of Capital
 What is Liquidity?
 Liquidity, Expected Returns and the Cost of Capital
 Liquidity and Adverse Selection
 What the Corporation Can Do
12-102
What is Liquidity?
 The idea that the expected return on a stock and the firm’s
cost of capital are positively related to risk is fundamental.
 Recently a number of academics have argued that the
expected return on a stock and the firm’s cost of capital
are negatively related to the liquidity of the firm’s shares as
well.
 The trading costs of holding a firm’s shares include
brokerage fees, the bid-ask spread and market impact
costs.
12-103
Liquidity, Expected Returns
and the Cost of Capital
 The cost of trading an illiquid stock reduces the total
return that an investor receives.
 Investors thus will demand a high expected return when
investing in stocks with high trading costs.
 This high expected return implies a high cost of capital to
the firm.
12-104
Liquidity and the Cost of Capital
Cost of Capital
Liquidity
An increase in liquidity, i.e. a reduction in trading costs,
lowers a firm’s cost of capital. 12-105
Liquidity and Adverse Selection
 There are a number of factors that determine the liquidity
of a stock.
 One of these factors is adverse selection.
 This refers to the notion that traders with better
information can take advantage of specialists and other
traders who have less information.
 The greater the heterogeneity of information, the wider
the bid-ask spreads, and the higher the required return
on equity.
12-106
What the Corporation Can Do
 The corporation has an incentive to lower trading costs
since this would result in a lower cost of capital.
 A stock split would increase the liquidity of the shares.
 A stock split would also reduce the adverse selection
costs thereby lowering bid-ask spreads.
 This idea is a new one and empirical evidence is not yet
in.
12-107
What the Corporation Can Do
 Companies can also facilitate stock purchases through
the Internet.
 Direct stock purchase plans and dividend reinvestment
plans handles on-line allow small investors the
opportunity to buy securities cheaply.
 The companies can also disclose more information.
Especially to security analysts, to narrow the gap
between informed and uninformed traders. This should
reduce spreads.
12-108
 The expected return on any capital budgeting project should be at
least as great as the expected return on a financial asset of
comparable risk. Otherwise the shareholders would prefer the firm
to pay a dividend.
 The expected return on any asset is dependent upon b.
 A project’s required return depends on the project’s b.
 A project’s b can be estimated by considering comparable
industries or the cyclicality of project revenues and the project’s
operating leverage.
 If the firm uses debt, the discount rate to use is the rWACC.
 In order to calculate rWACC, the cost of equity and the cost of debt
applicable to a project must be estimated.
12-109

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Corporate Finance

CAPITAL MARKET THEORY: AN OVERVIEW

dividend + change in market value

= dividend yield + capital gains yield

Year Return Your holding period return 

Year Return Geometric average return 

The probability that a yearly

 The 20.1-percent standard deviation we found for

THE CAPITAL ASSET PRICING MODEL (CAPM)

Consider the following two risky asset world. There is a 1/3

E (rS ) = 1 ´( -7%) + 1 ´(12%) + 1 ´(28%)

E (rB ) = 1 ´(17%) + 1 ´(7%) + 1 ´( -3%)

(11% 7%) = 3.24%

(11% 12%) = .01%

(11% 28%) = 2.89%

Expected return 11.00% 7.00% 9.0%

The rate of return on the portfolio is a weighted average of the

Expected return 11.00% 7.00% 9.0%

The rate of return on the portfolio is a weighted average of the

9.5% = 50% ´(12%) + 50% ´(7%)

Expected return 11.00% 7.00% 9.0%

The rate of return on the portfolio is a weighted average of the

Expected return 11.00% 7.00% 9.0%

The expected rate of return on the portfolio is a weighted average

Expected return 11.00% 7.00% 9.0%

where BS is the correlation coefficient between the returns on the

Expected return 11.00% 7.00% 9.0%

Observe the decrease in risk that diversification offers.

 If r = –1.0, complete risk reduction is possible

Portfolio Risk as a Function of the Number of

return Individual Assets

rf asset available and the efficient

rf Property states that the market portfolio, M, is

1 First Second Optimal

Clearly, your estimate of beta will depend upon your

Expected Return on the Market:

Market Risk Premium

• Assume b = 0, then the expected return is R .

σP = (wA σ A ) +(wB σB ) + 2(wB σB )(wA σ A )ρAB

 The CAPM states that the expected return on a security is

RISK, COST OF CAPITAL, AND CAPITAL BUDGETING

 To estimate a firm’s cost of equity capital, we need to know three

1. The risk-free rate, RF

 Suppose the stock of Stansfield Enterprises, a

B 2.5 $130 30% $0

C 2.5 $110 10% -$15.38

Beta - Sensitivity of a stock’s return to the return on the market

DOL = D EBIT Sales

Operating leverage increases as fixed costs rise

bAsset = Debt × bDebt + Equity × bEquity

 The Firm versus the Project

average b of assets = 1.3

24% Investments in hard

Project’s risk (b)

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