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Chapter 14

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17 views15 pages

Chapter 14

Uploaded by

sarah
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Chapter 14 –

Risk from the Shareholders’ Perspective

u Focus of the chapter is the mean-variance capital


asset pricing model (CAPM)
u Goal is to explain the relationship between risk and
required return
u CAPM is a simple model of a complex reality
The Key CAPM Relationship

u In an equilibrium market
(Ra) = Rf + a,m[E(Rm) - Rf]
u Where:
E(Ra) = expected return for an asset
Rf = Risk-free interest rate
a,m= Beta of the asset with regard to the market
portfolio
E(Rm) = Expected return for the market portfolio
Key Assumptions Underlying CAPM

u Investors choose portfolios based on expected


return and standard deviation
u Investors agree on expected returns, standard
deviations, and correlation for all assets
u Investors can borrow and lend at risk-free rate
u Frictionless markets: no taxes or transaction
costs, all investments completely divisible, no
single investor large enough to affect price
Uses of the CAPM Relationship

u Cost of capital calculations for a company


u Performance of a fully diversified stock or
portfolio. Expected relationship:
[Rp - Rf]/ p = [Rm - Rf]/ m
u Performance of a portfolio that is not fully
diversified, such as a sector fund:
(Rp - Rf)/ p,m = Rm - Rf
Usefulness of the CAPM

u CAPM is a simple model of a complex reality


u Standard for evaluation is not perfection in
explaining observed returns,
u Standard for evaluation is sufficient combination
of accuracy and simplicity for practical use
Accuracy of the CAPM
u Hundreds of tests have been conducted
u Explains differences in return between assets, but does not
explain all differences
u Factors other than beta appear to affect returns:
u Variance for the asset
u Stocks of small firms tend to provide higher returns
u Time-of-year effects
u Beta explains a relatively small portion of differences in
returns among stocks
u Most differences appear to be company-specific rather
than systematic
Application to Capital Budgeting

u CAPM provides risk-adjusted required return on


equity for the company
u CAPM can be applied if the risk-free rate, market
risk premium, and systematic risk of the asset
remain constant over time
u Typically assume a holding period equal to the
average life of the proposed project.
Application to Capital Budgeting

u Beta may be estimated using


u Historical returns for the company
u Betas for comparable companies
u Other methods such as state of nature models
Application to Capital Budgeting

u Must estimate expected return on the market


portfolio
u Long-term historical returns are commonly used
u Other methods such as analyst forecasts are also used
u There is still substantial debate as to the long-term
expected return for the market portfolio
u Historical returns may over-estimate expected returns
because a decrease in required return results in an
increase in realized return
Application to Capital Budgeting

u Risk-free rate
u Typically assume a long-term risk-free rate,
matching the average life of the asset.
Use in Capital Budgeting

u CAPM is widely used to estimate the required


return on equity for capital budgeting
u Firms frequently look at other risk measures as
well:
u Total project risk
u Impact of the project on company risk
International Investments

u The international application to capital budgeting is


often simplified to:
Ke = Rf + G[E(RG) – Rf]
Where
Rf = U.S. dollar-denominated risk-free rate
G = dollar denominated returns for the proposed
investment in relation to dollar-denominated
returns on the global market index
E(RG) = expected dollar-denominated return on
the global market index

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