Chapters 10 and 11

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Chapters 10 and 11
Risk, Return And the Opportunity Cost of Capital

Mila Getmansky Sherman
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Topics Covered

• Expected rate of return (cost of capital)
• Risk/return Relationship
• Measuring Risk
• Risk Diversification
• Measuring Market Risk
• Portfolio Betas
• CAPM and Expected Return
• Security Market Line

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Market Indexes
Dow Jones Industrial Average (The Dow) Value of
a portfolio holding one share in each of 30 large
industrial firms. Standard Poors Composite
Index (The SP 500) Value of a portfolio holding
shares in 500 firms. Holdings are proportional
to the number of shares in the issues.
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The Value of an Investment of 1 in 1900
Index
Year End
Source Ibbotson Associates
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Rates of Return
Common Stocks (1900-2001)
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Measuring Risk

• Variance - Average value of squared deviations
  from mean. A measure of volatility.
• Standard Deviation - Average value of squared
  deviations from mean. A measure of volatility.

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Measuring Risk

• Coin Toss Game-calculating variance and standard
  deviation

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Risk and Diversification

• Diversification - Strategy designed to reduce
  risk by spreading the portfolio across many
  investments.

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Risk and Diversification
Unique Risk - Risk factors affecting only that
firm. Also called diversifiable risk. Market
Risk - Economy-wide sources of risk that affect
the overall stock market. Also called
systematic risk.
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Risk and Diversification
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Measuring Market Risk

• Market Portfolio - Portfolio of all assets in the
  economy. In practice a broad stock market index,
  such as the SP Composite, is used to represent
  the market.
• Beta - Sensitivity of a stocks return to the
  return on the market portfolio.

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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

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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.

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Measuring Market Risk

• Example - continued

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Portfolio Betas

• Diversification decreases variability from unique
  risk, but not from market risk.
• The beta of your portfolio will be an average of
  the betas of the securities in the portfolio.
• If you owned all of the SP Composite Index
  stocks, you would have an average beta of 1.0

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Stock Betas
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Risk and Return
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Risk and Return
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Measuring Market Risk

• Market Risk Premium - Risk premium of market
  portfolio. Difference between market return and
  return on risk-free Treasury bills.

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Measuring Market Risk

• CAPM - 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.

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Measuring Market Risk

• Security Market Line - The graphic representation
  of the CAPM.

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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.

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Capital Budgeting Project Risk

• Example - 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. When evaluating a new dog food
  production investment, which cost of capital
  should be used?
• 1/3 Nuclear Parts Mfr.. B2.0
• 1/3 Computer Hard Drive Mfr.. B1.3
• 1/3 Dog Food Production B0.6
• AVG. B of assets 1.3

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Capital Budgeting Project Risk

• Example - 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. When evaluating a new dog food
  production investment, which cost of capital
  should be used?
• R 4 0.6 (14 - 4 ) 10
• 10 reflects the opportunity cost of capital on
  an investment given the unique risk of the
  project.