CHAPTER 6

Risk, Return, and the Capital Asset Pricing Model

Topics in Chapter

Basic return concepts Basic risk concepts Stand-alone risk Portfolio (market) risk Risk and return: CAPM/SML

Determinants of Intrinsic Value:

The Cost of Equity

Net operating profit after taxes Required investments in operating capital =

Free cash flow (FCF)

Value =

FCF1 FCF2 FCF ... + + + (1 + WACC)1 (1 + WACC)2 (1 + WACC)

Weighted average cost of capital (WACC)

Market interest rates

Market risk aversion

Cost of debt

Firms debt/equity mix

Firms business risk

Cost of equity

What are investment returns?

Investment returns measure the financial results of an investment. Returns may be historical or prospective (anticipated). Returns can be expressed in:

Dollar terms. Percentage terms.

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An investment costs $1,000 and is sold after 1 year for $1,100.

Dollar return: $ Received - $ Invested $1,100 - $1,000

= $100.

Percentage return: $ Return/$ Invested $100/$1,000

= 0.10 = 10%.
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What is investment risk?

Typically, investment returns are not known with certainty. Investment risk pertains to the probability of earning a return less than that expected. The greater the chance of a return far below the expected return, the greater the risk.
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Probability Distribution: Which stock is riskier? Why?

Stock A Stock B

-30

-15

15 Returns (%)

30

45

60

Consider the Following Investment Alternatives

Econ. Prob. T-Bill Alta Repo Am F. MP

Bust
Below avg. Avg. Above avg.

0.10 8.0% -22.0%

0.20 8.0 0.40 8.0 0.20 8.0 -2.0 20.0 35.0

28.0%
14.7 0.0 -10.0

10.0% -13.0%
-10.0 7.0 45.0 1.0 15.0 29.0

Boom

0.10 8.0
1.00

50.0

-20.0

30.0

43.0

What is unique about the Tbill return?

The T-bill will return 8% regardless of the state of the economy. Is the T-bill riskless? Explain.

Alta Inds. and Repo Men vs. the Economy

Alta Inds. moves with the economy, so it is positively correlated with the economy. This is the typical situation. Repo Men moves counter to the economy. Such negative correlation is unusual.

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Calculate the expected rate of return on each alternative.

^ r = expected rate of return.
^

r = riPi.
i=1

^ rAlta = 0.10(-22%) + 0.20(-2%) + 0.40(20%) + 0.20(35%) + 0.10(50%) = 17.4%.

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Alta has the highest rate of return. Does that make it best?
^

Alta Market Am. Foam T-bill Repo Men

17.4% 15.0 13.8 8.0 1.7

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What is the standard deviation of returns for each alternative?

= Standard deviation

= Variance = 2

i=1

(ri r)2 Pi.

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Standard Deviation of Alta Industries

= [(-22 - 17.4)20.10 + (-2 - 17.4)20.20 + (20 - 17.4)20.40 + (35 - 17.4)20.20 + (50 - 17.4)20.10]1/2 = 20.0%.

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Standard Deviation of Alternatives

T-bills Alta Repo Market = 0.0%. = 20.0%. = 13.4%. = 15.3%.

Am Foam = 18.8%.

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Stand-Alone Risk

Standard deviation measures the standalone risk of an investment. The larger the standard deviation, the higher the probability that returns will be far below the expected return.

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Expected Return versus Risk

Security Alta Inds.
Market Am. Foam T-bills Repo Men Expected Return 17.4% 15.0 13.8 8.0 1.7

Risk, 20.0%
15.3 18.8 0.0 13.4
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Coefficient of Variation (CV)

CV = Standard deviation / Expected return CVT-BILLS = 0.0% / 8.0% = 0.0. CVAlta Inds = 20.0% / 17.4% = 1.1. CVRepo Men = 13.4% / 1.7% = 7.9. CVAm. Foam = 18.8% / 13.8% = 1.4. CVM = 15.3% / 15.0% = 1.0.
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Expected Return versus Coefficient of Variation

Security Alta Inds Market Am. Foam Expected Return 17.4% 15.0 13.8 Risk: 20.0% 15.3 18.8 Risk: CV 1.1 1.0 1.4

T-bills
Repo Men

8.0
1.7

0.0
13.4

0.0
7.9
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Return vs. Risk (Std. Dev.): Which investment is best?

20.0% Alta 15.0% Mkt Am. Foam

Return

10.0% T-bills 5.0% Repo 0.0% 0.0% 5.0% 10.0% 15.0% 20.0% 25.0%

Risk (Std. Dev.)

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Portfolio Risk and Return

Assume a two-stock portfolio with $50,000 in Alta Inds. and $50,000 in Repo Men.

Calculate ^ rp and p.
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Portfolio Expected Return

^ rp is a weighted average (wi is % of portfolio in stock i): ^ rp = wi ^ ri
i=1
n

^ rp = 0.5(17.4%) + 0.5(1.7%) = 9.6%.

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Alternative Method: Find portfolio return in each economic state

Port.= 0.5(Alta) + 0.5(Repo) 3.0% 6.4 10.0 12.5

Economy Bust Below avg. Average Above avg. Boom

Prob. 0.10 0.20 0.40 0.20

Alta -22.0% -2.0 20.0 35.0

Repo 28.0% 14.7 0.0 -10.0

0.10

50.0

-20.0

15.0
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Use portfolio outcomes to estimate risk and expected return

^ rp = (3.0%)0.10 + (6.4%)0.20 + (10.0%)0.40 + (12.5%)0.20 + (15.0%)0.10 = 9.6% p = ((3.0 - 9.6)20.10 + (6.4 - 9.6)20.20 +(10.0 - 9.6)20.40 + (12.5 - 9.6)20.20 + (15.0 - 9.6)20.10)1/2 = 3.3% CVp = 3.3%/9.6% = .34
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Portfolio vs. Its Components

Portfolio expected return (9.6%) is between Alta (17.4%) and Repo (1.7%) returns. Portfolio standard deviation is much lower than:

either stock (20% and 13.4%). average of Alta and Repo (16.7%).

The reason is due to negative correlation (r) between Alta and Repo returns.

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Two-Stock Portfolios

Two stocks can be combined to form a riskless portfolio if r = -1.0. Risk is not reduced at all if the two stocks have r = +1.0. In general, stocks have r 0.35, so risk is lowered but not eliminated. Investors typically hold many stocks. What happens when r = 0?
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Adding Stocks to a Portfolio

What would happen to the risk of an average 1-stock portfolio as more randomly selected stocks were added? p would decrease because the added stocks would not be perfectly correlated, but the expected portfolio return would remain relatively constant.
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1 stock 35% Many stocks 20%

1 stock 2 stocks Many stocks

-75 -60 -45 -30 -15 0

15 30 45 60 75 90 10 5

Returns (%)
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Risk vs. Number of Stock in Portfolio

p
35%

Company Specific (Diversifiable) Risk Stand-Alone Risk, p

20%

Market Risk
0 10 20 30 40 2,000 stocks
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Stand-alone risk = Market risk + Diversifiable risk

Market risk is that part of a securitys stand-alone risk that cannot be eliminated by diversification. Firm-specific, or diversifiable, risk is that part of a securitys stand-alone risk that can be eliminated by diversification.

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Conclusions

As more stocks are added, each new stock has a smaller risk-reducing impact on the portfolio. p falls very slowly after about 40 stocks are included. The lower limit for p is about 20% = M . By forming well-diversified portfolios, investors can eliminate about half the risk of owning a single stock.
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Can an investor holding one stock earn a return commensurate with its risk?

No. Rational investors will minimize risk by holding portfolios. They bear only market risk, so prices and returns reflect this lower risk. The one-stock investor bears higher (stand-alone) risk, so the return is less than that required by the risk.
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How is market risk measured for individual securities?

Market risk, which is relevant for stocks held in well-diversified portfolios, is defined as the contribution of a security to the overall riskiness of the portfolio. It is measured by a stocks beta coefficient. For stock i, its beta is: bi = (ri,M i) / M
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How are betas calculated?

In addition to measuring a stocks contribution of risk to a portfolio, beta also measures the stocks volatility relative to the market.

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Using a Regression to Estimate Beta

Run a regression with returns on the stock in question plotted on the Y axis and returns on the market portfolio plotted on the X axis. The slope of the regression line, which measures relative volatility, is defined as the stocks beta coefficient, or b.
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Use the historical stock returns to calculate the beta for PQU.
Year 1 2 3 4 5 6 7 8 9 10 Market 25.7% 8.0% -11.0% 15.0% 32.5% 13.7% 40.0% 10.0% -10.8% -13.1% PQU 40.0% -15.0% -15.0% 35.0% 10.0% 30.0% 42.0% -10.0% -25.0% 25.0%

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Calculating Beta for PQU

50% 40% 30% 20% 10% 0% -10% -20% -30% -30% -20% -10% 0% 10%

PQU Return

rPQU = 0.8308 rM + 0.0256 R = 0.3546 20% 30% 40% 50%

2

Market Return
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What is beta for PQU?

The regression line, and hence beta, can be found using a calculator with a regression function or a spreadsheet program. In this example, b = 0.83.

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Calculating Beta in Practice

Many analysts use the S&P 500 to find the market return. Analysts typically use four or five years of monthly returns to establish the regression line. Some analysts use 52 weeks of weekly returns.
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How is beta interpreted?

If b = 1.0, stock has average risk. If b > 1.0, stock is riskier than average. If b < 1.0, stock is less risky than average. Most stocks have betas in the range of 0.5 to 1.5. Can a stock have a negative beta?
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Other Web Sites for Beta

Go to http://finance.yahoo.com Enter the ticker symbol for a Stock Quote, such as IBM or Dell, then click GO. When the quote comes up, select Key Statistics from panel on left.

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Expected Return versus Market Risk: Which investment is best?

Security Alta Market Am. Foam T-bills Repo Men Expected Return (%) 17.4 15.0 13.8 8.0 1.7 Risk, b 1.29 1.00 0.68 0.00 -0.86
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Use the SML to calculate each alternatives required return.

The Security Market Line (SML) is part of the Capital Asset Pricing Model (CAPM). SML: ri = rRF + (RPM)bi . Assume rRF = 8%; rM = rM = 15%. RPM = (rM - rRF) = 15% - 8% = 7%.

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Required Rates of Return

rAlta = 8.0% + (7%)(1.29) = 17%. rM = 8.0% + (7%)(1.00) = 15.0%. rAm. F. = 8.0% + (7%)(0.68) = 12.8%. rT-bill = 8.0% + (7%)(0.00) = 8.0%. rRepo = 8.0% + (7%)(-0.86) = 2.0%.

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Expected versus Required Returns (%)

Exp. r 17.4 15.0 13.8 8.0 1.7 Req. r 17.0 15.0 12.8 8.0 2.0

Alta Market Am. Foam T-bills Repo

Undervalued Fairly valued Undervalued Fairly valued Overvalued

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SML: ri = rRF + (RPM) bi ri = 8% + (7%) bi

ri (%)

rM = 15 rRF = 8 Repo -1

. T-bills

. .

Alta

Market

Am. Foam

Risk, bi
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Calculate beta for a portfolio with 50% Alta and 50% Repo
bp = = = = Weighted average 0.5(bAlta) + 0.5(bRepo) 0.5(1.29) + 0.5(-0.86) 0.22.

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Required Return on the Alta/Repo Portfolio?

rp = Weighted average r = 0.5(17%) + 0.5(2%) = 9.5%. Or use SML: rp = rRF + (RPM) bp = 8.0% + 7%(0.22) = 9.5%.
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Impact of Inflation Change on SML

r (%)

New SML
18 15 11 8

I = 3%

SML2
SML1

Original situation

0.5

1.0

1.5

Risk, bi

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Impact of Risk Aversion Change

r (%)

SML2
After change

18
15

SML1
RPM = 3%

Original situation 1.0

Risk, bi 50

Has the CAPM been completely confirmed or refuted?

No. The statistical tests have problems that make empirical verification or rejection virtually impossible.

Investors required returns are based on future risk, but betas are calculated with historical data. Investors may be concerned about both stand-alone and market risk.
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