Fundamentals of Corporate Finance Third edition Chapter 10 Risk Return Brealey Myers Marcus and capital Budgeting ndamentals of Corporate Finan Brealey Myers Marcus slides by Matthew will IrwinMcGraw-Hill CThe McGraw-Hill Companies, Inc, 2001
©The McGraw-Hill Companies, Inc.,2001 10- 1 Irwin/McGraw-Hill Chapter 10 Fundamentals of Corporate Finance Third Edition Risk, Return, and Capital Budgeting Brealey Myers Marcus slides by Matthew Will Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001
10-2 Topics Covered → Measuring beta S Portfolio betas OCAPM and Expected Return U Security market Line CApital Budgeting and Project Risk Irwin/McGraw-Hill CThe McGraw-Hill Commpanies, Inc, 2001
©The McGraw-Hill Companies, Inc.,2001 10- 2 Irwin/McGraw-Hill Topics Covered Measuring Beta Portfolio Betas CAPM and Expected Return Security Market Line Capital Budgeting and Project Risk
10-3 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 stocks return to the return on the market portfolio Irwin/McGraw-Hill CThe McGraw-Hill Commpanies, Inc, 2001
©The McGraw-Hill Companies, Inc.,2001 10- 3 Irwin/McGraw-Hill 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
10-4 Measuring Market Risk Example- Turbo Charged Seafood has the following returns on its stock, relative to the listed changes in the %o return on the market portfolio. The beta of Turbo Charged Seafood can be derived from this information Irwin/McGraw-Hill CThe McGraw-Hill Commpanies, Inc, 2001
©The McGraw-Hill Companies, Inc.,2001 10- 4 Irwin/McGraw-Hill 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
10-5 Measuring market Risk Example continued Month Market Return Turbo Return % +0.8 +1 +1.8 0.2 1.8 5 +0.2 0.8 Irwin/McGraw-Hill CThe McGraw-Hill Commpanies, Inc, 2001
©The McGraw-Hill Companies, Inc.,2001 10- 5 Irwin/McGraw-Hill Measuring Market Risk 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 Example - continued
10-6 Measuring Market Risk Example - continued S When the market was up 1%, Turbo average %o change was +0. 8% o When the market was down 1%. Turbo average %o change was.8% O 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 Irwin/McGraw-Hill CThe McGraw-Hill Commpanies, Inc, 2001
©The McGraw-Hill Companies, Inc.,2001 10- 6 Irwin/McGraw-Hill Measuring Market Risk 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. Example - continued
10-7 Measuring Market Risk Example - continued O When the market was up 1%, Turbo average %o change was +0.8% s When the market was down 1%o. Turbo average change was -0.8% OThe average change of 1.6%o(-08 to 0.8) divided by the 2%(-1.0 to 1.0)change in the market produces a beta of 0.8 B 2 0.8 Irwin/McGraw-Hill CThe McGraw-Hill Commpanies, Inc, 2001
©The McGraw-Hill Companies, Inc.,2001 10- 7 Irwin/McGraw-Hill Measuring Market Risk B = = 0.8 1.6 2 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. Example - continued
10-8 Measuring market Risk Example - continued Turbo return 0.8 0.6 0.4 Market Return 0.2 0 0.20.8-0.6-040.200204060.81 -0.4 -0.6 -0.8 Irwin/McGraw-Hill CThe McGraw-Hill Commpanies, Inc, 2001
©The McGraw-Hill Companies, Inc.,2001 10- 8 Irwin/McGraw-Hill Measuring Market Risk Example - continued -0.8 -0.6 -0.4 -0.2 0 0.2 0.4 0.6 0.8 1 -0.8 -0.6 -0.4 -0.2 0 0.2 0.4 0.6 0.8 1 Market Return % Turbo return %
10-9 Portfolio betas unique risk but not from market risk O Diversification decreases variability fro SThe beta of your portfolio will be an average of the betas of the securities in the portfolio SIf you owned all of the s&P Composite Index stocks, you would have an average beta of 1.0 Irwin/McGraw-Hill CThe McGraw-Hill Companies, Inc, 2001
©The McGraw-Hill Companies, Inc.,2001 10- 9 Irwin/McGraw-Hill 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 S&P Composite Index stocks, you would have an average beta of 1.0
1010 Measuring Market Risk Market Risk Premium-Risk premium of market portfolio. Difference between market return and return on risk-free Treasury bills 14 12 10 Market 8 Portfolio 6 62 0 0.2 0.4 0.6 0.8 Beta Irwin/McGraw-Hill CThe McGraw-Hill Commpanies, Inc, 2001
©The McGraw-Hill Companies, Inc.,2001 10- 10 Irwin/McGraw-Hill Measuring Market Risk Market Risk Premium - Risk premium of market portfolio. Difference between market return and return on risk-free Treasury bills. 0 2 4 6 8 10 12 14 0 0.2 0.4 0.6 0.8 1 Beta Expected Return (%) . Market Portfolio
