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FINE 3010-01 Financial Management

FINE 3010-01 Financial Management. Instructor: Rogério Mazali Lecture 13: 11/30/2011. FINE 3010-01 Instructor: Rogério Mazali. Fundamentals of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Alan J. Marcus McGraw Hill/Irwin. Chapter 12:

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FINE 3010-01 Financial Management

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  1. FINE 3010-01Financial Management Instructor: RogérioMazali Lecture 13: 11/30/2011

  2. FINE 3010-01Instructor: RogérioMazali Fundamentals of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Alan J. Marcus McGraw Hill/Irwin Chapter 12: Risk, Return, and Capital Budgeting

  3. Agenda • Measuring Market Risk • Measuring Beta • Betas for Amazon.com and Wal-Mart • Total Risk and Market Risk • Portfolio Betas • Risk and Return • Why the CAPM Makes Sense • The Security Market Line • How Well Does the CAPM work? • Using the CAPM to Estimate Expected Returns • Capital Budgeting and Project Risk • Company vs. Project Risk • Determinants of Project Risk

  4. Measuring Market Risk • Chapter 11: we have seen • Use Variance and Std. Dev. As measures of total risk of an asset • Risk can be reduced through diversification • Two types of risk: • Unique Risk (Idiosyncratic Risk) • Market Risk (Systematic Risk) • If investors are fully diversified, only market risk matters • Investors will only be compensated by incurring in extra market risk, not extra total risk • How to measure market risk?

  5. Measuring Market Risk • Different stocks have different exposures to market risk • How exposed a firm is to market risk? • We need a measure on how the firm’s stocks vary when compared to the market portfolio. • Statisticians gave us: • Covariance • Correlation Coefficient

  6. Measuring Market Risk • Back to original question: how to measure market risk? • Market Betas (or Market βs): measures how sensitive a security is to market movements • Generally we estimate β by OLS with a linear regression • Ri= αi+ βi* Rm • Generally, using the last 5 years of returns • Ri – Return on asset ‘i’ • Rm– Return on the marker (ex S&P 500) • αi& βi– Regression coefficients

  7. Measuring Market Risk

  8. Measuring Market Risk • Example:

  9. Measuring Market Risk

  10. Measuring Market Risk BetaA = Cov(RA, RM) / Var(RM) = 0.0324 / 0.0181

  11. Measuring Market Risk • β – tells us how sensitive a stock is to market movements • β > 1: amplify the overall movements of the market • 0 < β < 1: move in the same direction as the market, but not as far • β = 0: no correlation with the market, asset has no market risk • β < 0: asset is negatively correlated with the market, works as insurance against market downfalls

  12. Measuring Market Risk

  13. Measuring Market Risk Amazon.com Wal-Mart

  14. Measuring Market Beta • Portfolio betas: • The β of a portfolio equals the weighted average β of the component stocks • Example: You have invested 40% of your money in asset A whose beta is 1.5 and 60% in asset B whose beta is 0.5. What is the portfolio beta? • Portfolio beta = 0.4*1.5 + 0.6*0.5 = 0.9 • Market Portfolio beta:

  15. Risk and Return • We have seen that Unique risk can be eliminated through diversification • Investors who can diversify only car about market risk • We can use betas to predict expected returns • Stocks are future investments: have to be compensated for patience: expected return > risk-free rate (T-Bill) • Also, investors have to be compensated for incurring market risk, in the same proportion as their stocks are affected by changes in the market

  16. Risk and Return • This is known as the Capital Asset Pricing Model (CAPM). • Example: • Rf = 5% • Historical average market risk premium is 8.5% • β = 1.5, • β = 1 , • β = 0.5, • β = 0 , • β = -1 ,

  17. Risk and Return • Security Market Line (SML): Graphical Representation of CAPM, shows risk-return trade-off

  18. Risk and Return • How well does CAPM do in practice?

  19. Risk and Return • How well does CAPM do in practice?

  20. Capital Budgeting and Project Risk • Company beta vs. project beta • Suppose Dell Computers is consider a project in the pharmaceutical area. Does Dell’s beta tell anything about this project’s market risk? • A: No. • Which beta is preferable? Dell’s or Pfizer’s? • A: Pfizer’s. • Example: suppose our firm have a project whose IRR is 11%. The project is assumed to be as risky as the market, the current T-Bill rate is 3%, and the market historical risk premium is 7%. Should the company go forward with the project? • A: Yes. If the project’s risk/return point lies above the SML, project should go ahead.

  21. Capital Budgeting and Project Risk

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