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

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

3. Key Assumptions Underlying CAPM u Investors choose portfolios based on expected return and standard deviation u Investors agree on expected returns, standard deviations, and correlation for all assets u Investors can borrow and lend at risk-free rate u 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 u Cost of capital calculations for a company  Performance of a fully diversified stock or portfolio. Expected relationship: [R p - R f ]/  p = [R m - R f ]/  m  Performance of a portfolio that is not fully diversified, such as a sector fund: (R p - R f )/  p,m = R m - R f

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

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

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

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

9. Application to Capital Budgeting u Must estimate expected return on the market portfolio u Long-term historical returns are commonly used u Other methods such as analyst forecasts are also used u There is still substantial debate as to the long-term expected return for the market portfolio u 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 u Risk-free rate u Typically assume a long-term risk-free rate, matching the average life of the asset.

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

12. International Investments u The international application to capital budgeting is often simplified to: K e = R f +  G [E(R G ) – R f ] Where R f = 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(R G ) = expected dollar-denominated return on the global market index