Chapter Twelve: Risk, Return and

Capital Budgeting

FINC 210:
Financial Management

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 Topics
I. Market risk and Beta
II. Capital Asset Pricing Model & Security
Market Line
III. The Implication of CAPM: Calculate the
opportunity cost of capital for a project

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 I Market Risk and Beta
Market Portfolio is a portfolio of all assets in the economy.

We usually use stock market index, such as Hang Seng Ind

ex, as a proxy of the market portfolio in Hong Kong.

Changes in the value of the market portfolio represent the e

ffect of macro events to the economy. Therefore, all firm-sp
ecific risks are eliminated on a market portfolio.

Investors only bear market risk on investing in a market por

tfolio.
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 Market Risk and Beta
We can use the relation between an individual stocks return and the m
arket portfolios returns to measure the amount of market risk present i
n that stock.

If a stocks returns are highly (less) sensitive to the market portfolios re

turns, that stock is highly (less) sensitive to market risk. In this cas, this
stock should carry higher (lower) market risk.

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 Market Risk and Beta
Beta shows how strongly one stock responds to volatility of
the market portfolio.

Formal definition: Beta (a measure of market risk) measure

s the sensitivity of the securitys return to fluctuations in retu
rns on the market portfolio.

A company with a beta of 2.0 would be twice as volatile as t

he market, whereas a company with a beta of 0.5 would be
half as volatile as the market.

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Measuring Market risk (beta) of an individual stock

1. Collecting data on the returns on the market portfolio ove

r a specified time period.
2. Collecting data on the returns on a stock over the same t
ime period.
3. Graphing the returns on the stock against the returns on
the market.
4. Drawing a regression line through the points and measur
ing its slope.
5. The slope of the regression line is the stocks beta.

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 Example One
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 b
e derived from this information.
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
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I. Measuring Market risk

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 Portfolio Beta
Portfolio Beta The beta of a portfolio is th
e weighted average of the betas of the secur
ities in the portfolio. Portfolio weights repres
ent the respective percentages of a portfolio
s total value invested in each of the assets i
n the portfolio.

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 Example Two
Calculate the Beta of portfolio ABC
Stock Amount Portfolio Individual
Invested weight stocks beta
(1) (2) (3) (4) (3) * (4)
Stock A $6,000 50% 0.90 0.45
B 4,000 33 1.10 0.367
C 2,000 17 1.30 0.217
Portfolio $12,000 100% 1.034

Therefore, the beta of portfolio ABC is equal to 1.034.

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 Example Three
Suppose that in the coming year, you expe
ct ABCs stock to have a standard deviatio
n of 30% and a beta of 1.2, and GTMs sto
ck to have a standard deviation of 41% an
d a beta of 0.6.
Which stock carries more total risk?
Which has more market risk?

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Capital Asset Pricing Model (CAP
M) and Security Market Line
E[ Ri ] rf i E[ RMkt ] rf
1 4 42 4 43
Risk Premium for Security i

E(Ri) represents the expected return investors dem

and on asset i; rf represents the risk-free rate; i r
epresents the beta of asset i and E(RMkt) represent
s the expected return investors demand on a mark
et portfolio.
CAPM assumes that investors have well-diversified portfoli
os so that all firm-specific risks are totally eliminated.
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CAPM captures the linear relationship between systematic ri
sk (i.e. market risk) and expected return.

It states that the expected return of an asset is the sum of th

e risk-free rate and the expected risk premium.

The expected risk premium has two components; the beta a

nd the market risk premium. Market Risk Premium [E(rm)
rf ] is the additional compensation investors demand for inve
sting in the overall market.

Expected risk premium of a security depends on its market ri

sk, not its total risk.

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

Market risk premium =

Risk premium on any asset =
Expected return =
True or False
1. Investors demand higher expected rate of returns on sto
cks with more variable rate of returns.
2. The capital asset pricing model predicts that a security
with a beta of zero will provide an expected return of zer
o.
3. An investor who puts $10,000 in Treasury bills and $20,
000 in the market portfolio will have a portfolio beta of 2.
0
4. Investors demand higher expected rate of returns from
stocks with returns that are highly exposed to macroeco
nomic changes.
5. Investors demand higher expected rates of return from
stocks with returns that are very sensitive to fluctuations
in the stock market.
 Testing the CAPM
Beta vs. Average Risk
Avg Risk Premium
Premium 1931-
2010
30
Investors SML

20

10
Market
Portfolio
0
Portfolio Beta
1.0
Security Market Line
If the security market functions well, all securities should be
priced correctly such that they lie exactly on the Security M
arket Line (SML).

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 III. Implication of the CAPM
Basically, CAPM determines the cost of capital f
or the company as a whole. When a project und
er consideration has the same risk as the compan
y, it is fine to use the companys cost of capital as t
he project required rate of return. In case a project
involves more risk or less risk than the company a
s a whole, it is inappropriate to use the companys
cost of capital as its required rate of return.

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 Example Five
Suppose CTU Corporation is an all-equity firm (i.
e., no debt) with a beta of 1.21. Further suppose t
he market-risk premium is 8.5%, and the risk-free r
ate is 6%.

To evaluate the following non-mutually exclusive pr

ojects. Each project initially costs $100. All project
s are assumed to have the same risk.

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Project beta Expected CF IRR NPV at % Accept or
Reject
A 1.21 $140 40%

B 1.21 $120 20%

C 1.21 $110 10%

IR R (% )
Expected A
return /IRR 40
A ccept

B
20

1 6.3
10 C R eject

0
1.21 20