Finance
ADMS 3530 - Winter 2012 – Professor Lois King
Lecture 10 – Risk, Return and Capital Budgeting – Mar 13
10.1 Total Risk, Unique Risk & Market Risk
 Recall from Unit 9 – Total risk can be broken into two parts:
o Total risk – measured by Variance or Standard Deviation.
 Unique or Unsystematic Risk
 Can be diversified away.
 Caused by factors within a company’s operations (debt levels,
dividend yield, firm size, etc.)
 Market or Systematic Risk
 Non-diversifiable risk.
 Caused by macroeconomic factors (inflation, interest rates,
GDP growth, etc.)
 How can we calculate the level of Market Risk for a security?
o First, we need a market portfolio.
 In theory, the market portfolio is comprised of all risky assets that
exist in the world economy, such as stocks, bonds, commodities, real
estate, etc.
 In practice, analysts use a large equity index, such as the S & P 500, as
a benchmark.
o Beta of a stock – measures the sensitivity of a stock’s return to the return on
the market portfolio.
10.2 Measuring Market Risk
 Beta is a measure of market risk.
o The sensitivity of a stock’s returns to fluctuations in returns on the market.
o A measure of a stock’s exposure to changes in macroeconomic factors.
 How do you calculate the beta of a stock or a portfolio (from raw data)?
o Plot a chart of the returns of the market portfolio against the returns of stock
‘j’.
o Then find the line of ‘best fit’ (or what is known as the regression line);
o The slope of the line can be found by ordinary least squares regression
calculation;
o This slope is called a stock’s beta – Bj.
 Market portfolio – Beta = 1.0
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Aggressive Stocks – Beta > 1.0 (e.g. four seasons, ford)
Treasury Bills – Beta = 0 (risk-free asset)
Defensive stocks – Beta < 1.0 (e.g. Loblaw’s, Shoppers)
Portfolio Betas
o The beta of a portfolio is just the weighted-average of the betas of the
securities in the portfolio (where weights are the relative amount of
investment in each security).
 Beta of a portfolio = {fraction of portfolio in Stock 1 x Beta of stock 1}
+ {fraction of portfolio in Stock 2 x Beta of stock 2}
10.3 The Capital Asset Pricing Model
 Recall from unit 9, the cost of capital (or required rate of return) has 3 components:
o The real rate of return.
o The inflation rate.
o A risk premium.
 Required rate of return on any security = rate of return on treasury bills + security
risk premium
 CAPM states that the required return on any security depends:
o The risk-free rate (compensation for time value of money).
o The risk premium.
 The Security Market Line (SML)
o A graphical representation of CAPM.
o Denotes the required rate of return for any security (or project) if given its
beta (or level of systematic risk).
 If markets are efficient:
o All stocks should lie on the security market line.
 If markets are inefficient:
o If a security’s return lies on above the line, the security is a good investment
(that is it is providing a higher return than it should, given its level of risk as
measured by beta).
o If a security’s return lies below the line, the investment should not be
undertaken. The security’s return is not high enough for its level of risk.
10.4 Capital Budgeting & Project Risk
 Total risk = the standard deviation or variance of returns.
o Unique risk – can be diversified away.
o Systematic (or market) risk.
o Cannot be diversified away.
o Can be measured by beta  use CAPM to find ‘r’.
 Rules for project analysis:
o Discount the project’s cash flows at the project’s cost of capital. (This may or
may not be the firm’s cost of capital).
o Project cost of capital is based on the project risk.
o High operating leverage increases project risk  these projects have high
betas.
o The discount rate should only reflect the systematic risk of the project. It
should not be adjusted to offset potential errors or biases in the cash flow
forecast.
10.5 Summary
 Standard deviation or variance  measures total risk.
 Beta measures of the level of systematic risk of an asset.
o The beta of the market portfolio is 1.
o The beta of a risk-free asset (T-bill) is 0.
 The security market line (SML) is a graphical representation of CAPM.
o If returns plot above the SML = good investment.
o If return plot below the SML = poor investment.