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

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
portfolio
E(Rm) = Expected return for the market portfolio
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
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

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

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
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.

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
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
Application to Capital Budgeting
 Risk-free
rate
 Typically
assume a long-term risk-free rate,
matching the average life of the asset.
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
International Investments
 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