FIN 351: lecture 7

Risk, returns and WACC

CAPM and the capital
budgeting
Todays plan
Review what we have learned in the last
lecture
Risk
Portfolio
CAPM
The security market line
Portfolio rules
The application of CAPM in capital budgeting
WACC (Weighted Average Cost of Capital)

What have we learned in the
last lecture?
How to measure investment performance?
How to measure risk?
Two kinds of risk?
How to measure systematic risk?
What is the heuristic meaning of the Beta?
What is a portfolio?
How to calculate a portfolio weight?
What is the CAPM?
What is the basic idea behind CAPM?
What is the security market line?




Measuring Market Risk
Market Portfolio
It is a portfolio of all assets in the economy. In
practice a broad stock market index, such as the
S&P 500 is used to represent the market portfolio.
The market return is denoted by R
m
Beta ()
Sensitivity of a stocks return to the return on the
market portfolio,
Mathematically,
) (
) , (
m
m i
i
R Var
R r Cov
= |
An intuitive example for Beta
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.
Measuring Market Risk
(example, continue)
Month Market Return % 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
Measuring Market Risk
(continue)
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.
=1.6/2=0.8
Another example
Suppose we have following information:

State
Market Stock A Stock B
bad
good
-8% -10%
38%
-6%
24%
32%
a. What is the beta for each stock?
b. What is the expected return for each stock if each scenario is
equally likely?
c. What is the expected return for each stock if the probability
for good economy is 20%?
Solution
a.


b.

c.
09 . 0 ) 06 . 0 ( * 5 . 0 24 . 0 * 5 . 0
14 . 0 ) 1 . 0 ( * 5 . 0 38 . 0 * 5 . 0
= + =
= + =
B
A
r
r
75 . 0
40 . 0
30 . 0
) 08 . 0 ( 32 . 0
) 06 . 0 ( 24 . 0
2 . 1
40 . 0
48 . 0
) 08 . 0 ( 32 . 0
) 1 . 0 ( 38 . 0
= =


= |
= =


= |
B
A
0 ) 06 . 0 ( * 8 . 0 24 . 0 * 2 . 0
004 . 0 ) 1 . 0 ( * 8 . 0 38 . 0 * 2 . 0
= + =
= + =
B
A
r
r
Betas for the market portfolio
and risk-free investment
What is the beta of the market portfolio?

What is the beta of the risk-free security?
Market risk and risk premium
Risk premium for bearing market risk
The difference between the expected return
required by investors and the risk-free asset.
Example, the expected return on IBM is 10%,
the risk-free rate is 5%, and the risk premium
is 10% -5%=5%
If a security ( an individual security or a
portfolio) has market or systematic risk, risk-
averse investors will require a risk premium.
CAPM (Capital Asset Pricing
Model)
The risk premium on each security is
proportional to the market risk premium
and the beta of the security.
That is,



) (
f m i f i
r R r r | =
portf olio market the f or premium risk r R
i urity f or premium risk r r
f m
f i
=
= sec
Security market line (SML)
0
2
4
6
8
10
12
14
16
0 0.2 0.4 0.6 0.8 1 1.2
Beta
E
x
p
e
c
t
e
d

R
e
t
u
r
n

(
%
)

.

The graphic representation of CAPM in
the expected return and Beta plane
r
f
Security Market Line
R
m
Some true or false questions
1.A market index is used to measure performance of a
broad-based portfolio of stocks.
2. Long-term corporate bonds are riskier than common
stocks.
3.If one portfolio's variance exceeds that of another
portfolio, its standard deviation will also be greater
than that of the other portfolio.
4. Portfolio weights are always positive.

Some true or false questions
5. Standard deviation can be calculated as the square
of the variance.
6. Market risk can be eliminated in a stock portfolio
through diversification.
7. Macro risks are faced by all common stock investors.
8. The risk that remains in a stock portfolio after efforts
to diversify is known as unique risk.
9. We use the standard deviation or variance of stock
prices to measure the risk of a stock.

Portfolio rules
Rule 1: The realized return of a portfolio will be an weighted
average of the realized returns of the securities in the portfolio.


Rule 2: The expected return of a portfolio will be an weighted
average of the expected returns of the securities in the portfolio.


Rule 3: The Beta of a portfolio will be an weighted average of the
Betas of the securities in the portfolio.




i
n
i
i p
r x r

=
=
1
i
n
i
i p
r x r

=
=
1
i
n
i
i p
x | |

=
=
1
Example
Suppose you have a portfolio of IBM and
Dell with a beta of 1.2 and 2.2,
respectively. If you put 50% of your
money in IBM, and the other in Dell,
what is the beta of your portfolio

Beta of your portfolio =0.5*1.2 +0.5*2.2=1.7
Project Risk and cost of the capital
In capital budgeting, in order to calculate the
NPV of the project, we need to measure the
risk of the project and thus find out the
discount rate (the cost of capital)
We can use Beta of the project cash flows to
measure the risk of the project and use CAPM
to get the expected return required by
investors

) (
f m project f project
r R r r | + =
Example 1
Based on the CAPM, ABC Company has a
cost of capital of 17%. (4 + 1.3(10)). A
breakdown of the companys investment
projects is listed below.
1/3 Nuclear Parts: =2.0
1/3 Computer Hard Drive: =1.3
1/3 Dog Food Production: =0.6
When evaluating a new dog food production
investment, which cost of capital should be
used and how much?


Solution
Since dog food projects may have
similar systematic risk to the dog food
division, we use a beta of 0.6 to measure
the risk of the projects to be taken.

Thus the expected return on the project
or the cost of capital is
0.04+0.6*(0.1)=0.l or 10%
Example 2
Stock A has a beta of .5 and investors
expect it to return 5%. Stock B has a
beta of 1.5 and investors expect it to
return 13%. What is the market risk
premium and the expected rate of return
on the market portfolio?
Solution
According to the CAPM
% 9
% 1
) ( * 5 . 1 13
) ( * 5 . 0 5
=
=
+ =
+ =
m
f
f m f
f m f
R
r
r R r
r R r
Example 3
You have $1 million of your own money
and borrow another $1 million at a risk-
free rate of 4% to invest in the market
portfolio. The expected return for the
market portfolio is 12%, what is the
expected return on your portfolio?
Solution
We can use two approaches to solve it:
First, the expected rate of return of a portfolio
is the weighed average of the expected rates
of return of the securities in the portfolio.
Second , the beta of a portfolio is the weighed
average of the betas of the securities in the
portfolio. Then use the CAPM to get the
expected rate of return.
Solution (continue)
First approach



Second approach
% 20 12 * 2 4 * 1
2
1
2
; 1
1
1
2 ; 1 ; 1 $
= + =
= = =

=
= = =
p
m f
m f
R
x x
W W W
% 20 8 * 2 4
2 1 * 2 0 * 1
2
1
2
; 1
1
1
2 ; 1 ; 1 $
= + =
= + = |
= = =

=
= = =
p
p
m f
m f
R
x x
W W W
The cost of capital
Cost of Capital
The expected return the firms investors
require if they invest in securities or projects
with comparable degrees of risk.


WACC to approximate the cost
of capital or discount rate
Weighted -average cost of capital=

e
V
E
d
V
D
r + Tc)r - (1 = WACC
Summary of WACC calculation
Three steps in calculating WACC
First step: Calculate the portfolio weight using
the market value.
Second step: Determine the required rate of
return on each security in the portfolio.
Third step: Calculate a weighted average of
these returns, or the expected return on the
portfolio.

WACC calculation(continue)
In calculating WACC, we have to use
market values of debt and equity.
Even if you are given the book value of
debt, you may convert this book value to
market debt value to calculate WACC
Why do we use market values of debt
and equity, but not book values of debt
and equity, in calculating WACC?
The cost of capital for the bond
The cost of capital for the bond
It is the YTM, the expected return required by
the investors.
That is


The expected return on a bond can also be
calculated by using CAPM

( ) ( )
t
d d
d r
principal cpn
r
cpn
r
cpn
+
+
+ +
+
+
+
=
1 1
1
P
2
bond

) (
f m d f d
r R r r | + =
Example 2
A bond with a face value of $2000
matures in 5 years. The coupon rate is
8%. If the market price for this bond is
$1900.
(a) What is the expected return on this bond or
what is the cost of debt or interest rate for this
bond?
(b) Suppose that the YTM is 9%, what is the
market value of this bond?

Solution
(a)



(b)

% 3 . 9
) 1 (
2000
) 1 (
1 1
160 1900
5 5
=
+
+
|
|
.
|

\
|
+
=
YTM
YTM YTM YTM YTM
922 , 1 $
09 . 1
2000
09 . 1 * 09 . 0
1
09 . 0
1
160
5 5
= +
|
|
.
|

\
|
=
bond
P
The cost of capital for a stock
The cost of capital for a stock is
calculated by using
CAPM


Dividend growth model



) r - (R + r = r
f m f e i
|
g
P
DIV
r
g r
DIV
P
e
e
+ =

=
0
1 1
0
Example 3
Sock A now pays a dividend of $1.5 per
share annually, It is expected that
dividend is going to grow at a constant
rate of 2%. The current price for stock A
is $25 per share. What is the expected
return or the cost of capital by investing
in this stock?
Solution
% 12 . 8
02 . 0
02 . 1 * 5 . 1
25 =

= r
r
Using the dividend discount model, we have
Example 4
Geothermal Inc. has two securities:
debt and stocks. The market debt value
is $194 million, but the firms market
value is $647 million. Given that
geothermal pays 8% for debt and 14%
for equity, what is the Company Cost of
Capital (There is no corporate tax)?

Solution
% 2 . 12 14 . 0 *
647
453
08 . 0 *
647
194
= + = WACC
Example 5
Executive Fruit has issued debt,
preferred stock and common stock.
The market value of these securities
are $4mil, $2mil, and $6mil,
respectively. The required returns are
6%, 12%, and 18%, respectively.
What is the WACC for Executive Fruit, Inc.?

Solution
% 13
18 . 0 *
12
6
12 . 0 *
12
2
06 . 0 *
12
4
12 6 2 4
=
+ + =
= + + =
WACC
V
Example 6 (with tax)
Geothermal Inc. has two securities:
debt and stocks. The market debt value
is $194 million, but the firms market
value is $647 million. Given that
geothermal pays 8% for debt and 14%
for equity, what is the Company Cost of
Capital if the tax rate is 50%?

Solution
% 11 14 . 0 *
647
453
5 . 0 * 08 . 0 *
647
194
= + = WACC