Chapter 14 – Risk from the Shareholders’ Perspective

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]
E(Ra) = expected return for an asset
Rf = Risk-free interest rate
a,m= Beta of the asset with regard to the market
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
 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
 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
 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]
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