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Corporate Finance Lecture 2

Corporate Finance Lecture 2. Risk, Return and the Capital Budget. This chapter introduces the quantitative techniques used to estimate the required returns on equity. It also establishes the relationship between market risk and the relative riskiness of the firm. Measuring Market Risk.

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Corporate Finance Lecture 2

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  1. Corporate Finance Lecture 2

  2. Risk, Return and the Capital Budget This chapter introduces the quantitative techniques used to estimate the required returns on equity. It also establishes the relationship between market risk and the relative riskiness of the firm.

  3. Measuring Market Risk • Market Portfolio - Portfolio of all assets in the economy. • Beta - Sensitivity of a stock’s return to the return on the market portfolio.

  4. Measuring Beta: Example Example – The Fosterhouse Gourmet Foods corporation has the following % returns on its stock, relative to the listed changes in the % return on the market portfolio. Its beta (β) can be derived from this information. * The returns are expressed as percentages, though the results will be identical if expressed as decimals.

  5. Measuring Beta: Example (ctd) • When the market was up 1%, Fosterhouse Corporation’s average percent change was +.4%. • When the market was down 1%, Fosterhouse Corporation’s average percent change was -.4%. • The change of .8% (-.4% to .4%) divided by the 2% (-1.0% to 1.0%) change in the market produces a beta of .4.

  6. Measuring Beta Graphically Fosterhouse Corporation Returns (%)

  7. Stock Betas for Common Stocks(May 2005 - April 2010) What factors contribute to the variation in these betas?

  8. Total Risk and Market Risk Recall that total risk is a combination of unique risk and market risk. What are the effects of diversification on unique risk and market risk?

  9. Portfolio Beta • The beta of your portfolio will be an average of the betas of the securities in the portfolio. • What would be the average beta if you owned all of the S&P Composite Index stocks? • What is the beta of the risk-free return, U.S. Treasury Bills?

  10. Portfolio Beta: Example Example – Calculate the beta of a portfolio that consists of 25% Ford, 25% Boeing, and 50% McDonald’s.

  11. Measuring Market Risk:The Market Risk Premium Market Risk Premium - Risk premium of market portfolio; the difference between the market return and the return on risk-free Treasury bills.

  12. Market Risk Premium: Example Example: Market Portfolio (market return = 12%)

  13. Capital Asset Pricing Model (CAPM) Let r = expected return on any asset * Note: These are identical, the risk-free rate has just been moved to the right hand side.

  14. CAPM: Example

  15. Graphic Representation of CAPM Security Market Line - The relationship between expected return and beta.

  16. CAPM Tested Beta vs. Average Risk Premium What do these results imply?

  17. Alternative Explanations to CAPM Small minus big High minus low book-to-market http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html

  18. Alternative Explanations Tested http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html

  19. CAPM and Expected Returns Is CAPM useful?

  20. Project Risk and theSecurity Market Line • Company Cost of Capital:Expected rate of return demanded by investors in a company, determined by the average risk of the company’s securities • Project Cost of Capital:Minimum acceptable expected rate of return on a project given its risk. Which should be used to assess the value of a proposed project?

  21. Determinants of Project Risk • Consider: • Operating Leverage and Project Risk • The presence of non-diversifiable risk

  22. Project Risk and theSecurity Market Line Should this project be accepted? Why? What does this imply, if anything, about this project’s NPV?

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