Chapter 14 – Risk from the Shareholders’ Perspective

1. Chapter 14 – Risk from the Shareholders’ Perspective • Focus of the chapter is the mean-variance capital asset pricing model (CAPM) • Goal is to explain the relationship between risk and required return • CAPM is a simple model of a complex reality

2. The Key CAPM Relationship • In an equilibrium market (Ra) = Rf + a,m[E(Rm) - Rf] • Where:E(Ra) = expected return for an asset Rf = Risk-free interest ratea,m= Beta of the asset with regard to the market portfolioE(Rm) = Expected return for the market portfolio

3. Key Assumptions Underlying CAPM • Investors choose portfolios based on expected return and standard deviation • Investors agree on expected returns, standard deviations, and correlation for all assets • Investors can borrow and lend at risk-free rate • Frictionless markets: no taxes or transaction costs, all investments completely divisible, no single investor large enough to affect price

4. Uses of the CAPM Relationship • Cost of capital calculations for a company • Performance of a fully diversified stock or portfolio. Expected relationship: [Rp - Rf]/p = [Rm - Rf]/ m • Performance of a portfolio that is not fully diversified, such as a sector fund: (Rp - Rf)/p,m = Rm - Rf

5. Usefulness of the CAPM • CAPM is a simple model of a complex reality • Standard for evaluation is not perfection in explaining observed returns, • Standard for evaluation is sufficient combination of accuracy and simplicity for practical use

6. Accuracy of the CAPM • Hundreds of tests have been conducted • Explains differences in return between assets, but does not explain all differences • Factors other than beta appear to affect returns: • Variance for the asset • Stocks of small firms tend to provide higher returns • Time-of-year effects • Beta explains a relatively small portion of differences in returns among stocks • Most differences appear to be company-specific rather than systematic

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

8. Application to Capital Budgeting • Beta may be estimated using • Historical returns for the company • Betas for comparable companies • Other methods such as state of nature models

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

10. Application to Capital Budgeting • Risk-free rate • Typically assume a long-term risk-free rate, matching the average life of the asset.

11. Use in Capital Budgeting • CAPM is widely used to estimate the required return on equity for capital budgeting • Firms frequently look at other risk measures as well: • Total project risk • Impact of the project on company risk

12. International Investments • The international application to capital budgeting is often simplified to: Ke = Rf + G[E(RG) – Rf] WhereRf = 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