Business & Corporate Finance

(BCF)
Date: December 30, 2022
Session 18 : Risk and Return
Instructor : Dr. Neharika Sobti
Term 2, PGDM (Core) 2022-2023, Section G
IMT Ghaziabad
Agenda
• Estimation of Expected Return
• Probability Distribution of Return
• Estimation of Risk
• Portfolio Return and Risk
• Role of Diversification
• Covariance and Correlation
• Beta
• Efficient Frontier and Efficient Portfolio
• CAPM and its assumptions
Risk and Return
Why does stock price change ?

• What factors cause cash flows to change ?

• What factors cause Discount factor to change ?

• Firm Specific Risk Factors -

• Diversifiable
• Unsystematic Risk
• Idiosyncratic

• Common Macro Risk Factors –

• Non-Diversifiable
• Systematic Risk
• Market Risk
Common Versus Independent Risk
• Common Risk
• Risk that is perfectly correlated
• Risk that affects all securities

• Independent Risk
• Risk that is uncorrelated
• Risk that affects a particular security

• Diversification
• The averaging out of independent risks in a large portfolio
Diversification in Stock Portfolios (cont'd)
• Firm-Specific Risk
• Independent Risks
• Due to firm-specific news
• Also known as:
• Firm-Specific Risk
• Idiosyncratic Risk
• Unique Risk
• Unsystematic Risk
• Diversifiable Risk
Diversification in Stock Portfolios (cont'd)
• Systematic Risk
• Common Risks Factors
• Due to market-wide news
• Also known as:
• Systematic Risk
• Undiversifiable Risk
• Market Risk
Risk: Systematic and Unsystematic
• A systematic risk is any risk that affects a large number of assets, each
to a greater or lesser degree.
• An unsystematic risk is a risk that specifically affects a single asset or
small group of assets.
• Unsystematic risk can be diversified away.
• Examples of systematic risk include uncertainty about general
economic conditions, such as GNP, interest rates or inflation.
• On the other hand, announcements specific to a single company are
examples of unsystematic risk.
Total Risk
• Total risk = systematic risk + unsystematic risk
• The standard deviation of returns is a measure of total risk.
• For well-diversified portfolios, unsystematic risk is very small.
• Consequently, the total risk for a diversified portfolio is essentially
equivalent to the systematic risk.
Diversification in Stock Portfolios (cont'd)
• Firm-Specific Versus Systematic Risk

• When many stocks are combined in a large portfolio, the

firm-specific risks for each stock will average out and be
diversified.

• The systematic risk, however, will affect all firms and will
not be diversified.
Problem set 3
• Firm-Specific Versus Systematic Risk
• Consider two types of firms:
• Type S firms are affected only by systematic risk. There is a 50%
chance the economy will be strong and type S stocks will earn a
return of 40%;
• There is a 50% change the economy will be weak and their return
will be –20%.
• Because all these firms face the same systematic risk, holding
a large portfolio of type S firms will not diversify the risk.
Problem set 3
• Firm-Specific Versus Systematic Risk
• Consider two types of firms:
• Type I firms are affected only by firm-specific risks.
Their returns are equally likely to be 35% or –25%,
based on factors specific to each firm’s local market.
Diversification in Stock Portfolios
• Firm-Specific Versus Systematic Risk
• Actual firms are affected by both market-wide risks and firm-specific risks.
When firms carry both types of risk, only the unsystematic risk will be
diversified when many firm’s stocks are combined into a portfolio.

• The volatility will therefore decline until only the systematic risk remains.
Volatility of Portfolios of Type S and I Stocks
Problem set 3
Portfolio Risk and Number of Stocks
In a large portfolio the variance terms are
 effectively diversified away, but the covariance
terms are not.
Diversifiable Risk;
Nonsystematic Risk;
Firm Specific Risk;
Unique Risk
Portfolio risk
Nondiversifiable risk;
Systematic Risk;
Market Risk
n
What is a Portfolio ?
• Portfolio is a Combination of Assets

• Expected Return on Portfolio - ?

• Risk of Portfolio - ?
Expected Return of Portfolio
Risk of Portfolio
Risk of Portfolio
Covariance
Correlation
Correlation
Comparing Beta and Correlation
Comparing Beta and Correlation
Beta is measure of
• Relative Volatility

• Sensitivity of a stock to movements in the overall market

• Beta > 1

• Beta <1

• Beta = 1
CORE CURRICULUM
Return Patterns for Stocks with
Differing Betas
CORE CURRICULUM
Summary of Covariance, Correlation, and
Beta of Selected Stocks with the S&P 500
(Based on Weekly Data for the Year 2015)
CORE CURRICULUM
Characteristics of a Portfolio with
Two Risky Assets
Expected Return of Portfolio
• Weighted average of expected return of individual stocks with
weights as the proportion of investment in each stock

• Find the expected return of portfolio?

CORE CURRICULUM
Effect of Correlation on Portfolio Standard
Deviation (Given σA = 20% and σB = 28%)
CORE CURRICULUM
Effect of Correlation on Portfolio Standard
Deviation (Given σA = 20% and σB = 28%)
In which case portfolio standard deviation is
lower than individual one ?
In which case portfolio standard deviation is
lower than individual one ?
Main Question
• Is it possible to reduce portfolio risk without sacrificing expected return?

• Portfolio reduces which type of risk ??

• Does adding more stocks to portfolio reduced risk ?

• How many stock should I add to the stock ?

What is Diversification?
• Diversification is reduction of return volatility (risk) that occurs when
combining assets that are less than perfectly positively correlated.

• How much risk we eliminate with diversification?

• Which type of Risk can be diversified ?
Diversification and Portfolio Returns
without correlation
Diversification and Portfolio Returns
with correlation
How should investors diversify ?
• Are there any portfolio better than rest ?

• What are collection of all combination of feasible portfolios made of

different combination of 5 stocks ?

• Efficient Portfolio Frontier

• Region of Feasible Portfolios

Portfolio combination and Efficient Frontier
• From given set of possible portfolio, which one will you choose and
why ?

• Risk Averse investor will chose that portfolio which gives highest
expected return for a given amount of risk

• Dominant Portfolio – Efficient Portfolio – highest expected return for

a given amount of risk
Portfolio combination and Efficient Frontier
• How to identify set of efficient portfolio ?
CORE CURRICULUM
Portfolio Combinations and
the Efficient Frontier
Efficient Frontier
• All dominant portfolios that gives highest return for a given level of
risk or least risk for a given expected return

• Risk Averse investor will prefer atleast one portfolio on efficient

frontier to non- efficient frontier

• No one best portfolio is deemed for all type of investors as investors

chose best portfolio depending upon their risk tolerance
Adding Risk Free Rate to Risky portfolio
• Where will you plot Rf on u-sigma space ?

•l

• Combination of Risk Free and Risky Asset

• Why is it a straight line ?
What is slope of straight line Rf and Risky
Asset?
Which portfolio A or B will chose and why ?
Does investor only invest in risky assets ?
Borrowing and Lending Rf
• Point F is 100% money invested in Risk Free Asset

• Point A is 100% money invested in Risk Asset A

• What about point beyond A ?

• Invested more than 100% in A ,but How ?

• By having negative weights in Rf ??
• Borrowing Rf to invest in A beyond 100%
CORE CURRICULUM
Combinations of a Risky Asset with the
Risk-Free Asset, with Borrowing and Lending
Tangency Portfolio
• How to chose which combination of riskfree and risky asset to chose
as portfolio ?

• Tangency Portfolio
CORE CURRICULUM
The Efficient Frontier and
the Tangency Portfolio
Tangent Portfolio
• The point at which the straight line connecting Risk Free Rate to Risky
Asset is tangent to Efficient Frontier is called Tangency Portfolio

• It is best of best portfolio because

• Maximum Sharpe Ratio ,with risk free and risky asset

Risk Premium for which risk ?
• The risk premium for diversifiable risk is zero, so investors are not
compensated for holding firm-specific risk.

• If the diversifiable risk of stocks were compensated with an additional

risk premium, then investors could buy the stocks, earn the additional
premium, and simultaneously diversify and eliminate the risk.
No Arbitrage
and the Risk Premium (cont'd)
• The risk premium of a security is determined by its systematic risk
and does not depend on its diversifiable risk.

• This implies that a stock’s volatility, which is a measure of total risk

(that is, systematic risk plus diversifiable risk), is not especially useful
in determining the risk premium that investors will earn.
How to measure systematic risk ?
• Standard deviation is not an appropriate measure of risk for an
individual security.

• There should be no clear relationship between volatility and average

returns for individual securities.

• Consequently, to estimate a security’s expected return, we need to

find a measure of a security’s systematic risk.
Measuring Systematic Risk
• To measure the systematic risk of a stock, determine how much of
the variability of its return is due to systematic risk versus
unsystematic risk.

• To determine how sensitive a stock is to systematic risk, look at the

average change in the return for each 1% change in the return of a
portfolio that fluctuates solely due to systematic risk.
Measuring Systematic Risk
• Efficient Portfolio
• A portfolio that contains only systematic risk. There is no way to reduce the
volatility of the portfolio without lowering its expected return.

• Market Portfolio
• An efficient portfolio that contains all shares and securities in the market
• The S&P 500 is often used as a proxy for the market portfolio.
Measuring Systematic Risk
• Sensitivity to Systematic Risk: Beta (β)

• The expected percent change in the excess return of a

security for a 1% change in the excess return of the market
portfolio.

• Beta differs from volatility. Volatility measures total risk (systematic

plus unsystematic risk), while beta is a measure of only systematic
risk.
Measuring Systematic Risk (cont'd)
• Interpreting Beta (β)
• A security’s beta is related to how sensitive its underlying revenues and
cash flows are to general economic conditions.

• Stocks in cyclical industries are likely to be more sensitive to

systematic risk and have higher betas than stocks in less sensitive
industries.
Beta and the Cost of Capital
• Estimating the Risk Premium
• Market risk premium
• The market risk premium is the reward investors expect to earn for holding a portfolio
with a beta of 1.

Market Risk Premium  E  RMkt   rf

Beta and Cost of Capital (cont'd)
• Adjusting for Beta
• Estimating a Traded Security’s Cost of Capital of an investment from Its Beta

E  R   Risk-Free Interest Rate  Risk Premium

 rf    (E  RMkt   rf )
• Problem
• Assume the economy has a 60% chance of the market return will 15% next
year and a 40% chance the market return will be 5% next year.
• Assume the risk-free rate is 6%.
• If Microsoft’s beta is 1.18, what is its expected return next year?
Expected Return of a Portfolio
• Portfolio Weights
• The fraction of the total investment in the portfolio held in each individual
investment in the portfolio
• The portfolio weights must add up to 1.00 or 100%.

Value of investment i
xi 
Total value of portfolio
• Problem
• Suppose you buy 500 shares of Ford at $11 per share and 100 shares
of Citigroup stock at $28 per share. If Ford’s share price goes up to $13
and Citigroup’s rises to $40, what is the new value of the portfolio, and
what return did it earn?
• After the price change, what are the new portfolio weights?
• Solution
• The initial value of the portfolio is 500 * $11 + 100 * $28 = $8,300.

• The new value of the portfolio is 500 * $13 + 100 * $40 = $10,500, for
a gain of $2,200 or a 26.5% return on your $8,300 investment.

• Ford’s return was $13/$11 - 1 = 18.18%, and Citigroup’s was $40/$28 -

1 = 42.86%.
• Solution
• Given the initial portfolio weights of $5,500/$8,300 = 66.3% for Ford
and $2,800/$8,300 = 33.7% for Citigroup, we can also compute the
portfolio’s return f:

RP  x Ford RFord  xCitgroup RCitigroup

= .663  18.2% + .337  42.9%  26.5%
• Solution
• After the price change, the new portfolio weights are $6,500/$10,500 =
61.9% for Ford and $4,000/$10,500 = 38.1% for Citigroup.
Diversification with an Equally Weighted
Portfolio
• Equally Weighted Portfolio
• A portfolio in which the same amount is invested in each stock

• Variance of an Equally Weighted Portfolio

of n Stocks
1
Var ( RP )  (Average Variance of the Individual Stocks)
n
 1
 1   (Average Covariance between the Stocks)
 n
Risk Versus Return:
Choosing an Efficient Portfolio
• Efficient Portfolios with Two Stocks

• Identifying Inefficient Portfolios

• In an inefficient portfolio, it is possible to find another portfolio that is better in terms of
both expected return and volatility.

• Identifying Efficient Portfolios

• in an efficient portfolio there is no way to reduce the volatility of the portfolio without
lowering its expected return.
 Choosing an Efficient Portfolio
Efficient Portfolios with Two Stocks
• Consider a portfolio of Intel and Coca-Cola

Expected Returns and Volatility for Different Portfolios of Coca Cola and Intel
Volatility Versus Expected Return for Portfolios of Intel and Coca-Cola Stock
Choosing an Efficient Portfolio (cont'd)

• Efficient Portfolios with Two Stocks

• Consider investing 100% in Coca-Cola stock.

• As shown in on the previous slide, other portfolios—such as the portfolio

with 20% in Intel stock and 80% in Coca-Cola stock—make the investor better
off in two ways:
• It has a higher expected return, and it has lower volatility.
• As a result, investing solely in Coca-Cola stock is inefficient.
The Effect of Correlation
• Correlation has no effect on the expected return of a portfolio. However, the
volatility of the portfolio will differ depending on the correlation.
• The lower the correlation, the lower the volatility we can obtain. As the
correlation decreases, the volatility of the portfolio falls.
• The curve showing the portfolios will bend to
the left to a greater degree as shown on the
next slide.
Effect on Volatility and Expected Return of Changing the Correlation between Intel
and Coca-Cola Stock
Efficient Portfolios with Many Stocks
• Consider adding Bore Industries to the two stock portfolio:

• Although Bore has a lower return and the same volatility as Coca-Cola, it still may be
beneficial to add Bore to the portfolio for the diversification benefits.
Expected Return and Volatility for Selected Portfolios of Intel, Coca-Cola, and Bore
Industries Stocks
Volatility and Expected Return for All Portfolios of Intel, Coca-Cola, and Bore Stock
Risk Versus Return: Many Stocks
• The efficient portfolios, those offering the highest possible expected
return for a given level of volatility, are those on the northwest edge
of the shaded region, which is called the efficient frontier for these
three stocks.

• In this case none of the stocks, on its own, is on the efficient frontier, so it
would not be efficient to put all our money in a single stock.
Efficient Frontier with Ten Stocks Versus Three
Stocks
Risk-Free Saving and Borrowing
• Risk can also be reduced by investing a portion of a portfolio in a risk-free
investment, like T-Bills. However, doing so will likely reduce the expected return.

• On the other hand, an aggressive investor who is seeking high expected returns
might decide to borrow money to invest even more in the stock market.
Investing in Risk-Free Securities
• Consider an arbitrary risky portfolio and the effect on risk and return
of putting a fraction of the money in the portfolio, while leaving the
remaining fraction in risk-free Treasury bills.
• The expected return would be:

E [RxP ]  (1  x)rf  xE[RP ]

 rf  x (E[RP ]  rf )
Investing in Risk-Free Securities (cont'd)
• The standard deviation of the portfolio would be calculated as:

SD[RxP ]  (1  x) 2Var (rf )  x 2Var (RP )  2(1  x)xCov(rf ,RP )

 x 2Var (RP )
0
 xSD(RP )
• Note: The standard deviation is only a fraction of the volatility of the risky
portfolio, based on the amount invested in the risky portfolio.
Risk–Return Combinations from Combining a Risk-Free Investment and a Risky
Portfolio
Identifying the Tangent Portfolio
• To earn the highest possible expected return for any level of
volatility we must find the portfolio that generates the steepest
possible line when combined with the risk-free investment.
Identifying the Tangent Portfolio (cont'd)
• Sharpe Ratio
• Measures the ratio of reward-to-volatility provided by a portfolio

Portfolio Excess Return E[RP ]  rf

Sharpe Ratio  
Portfolio Volatility SD( RP )

• The portfolio with the highest Sharpe ratio is the portfolio where the line
with the risk-free investment is tangent to the efficient frontier of risky
investments. The portfolio that generates this tangent line is known as the
tangent portfolio.
Tangent or Efficient Portfolio
Identifying the Tangent Portfolio (cont'd)
• Combinations of the risk-free asset and the tangent portfolio provide
the best risk and return tradeoff available to an investor.
• This means that the tangent portfolio is efficient and that all efficient
portfolios are combinations of the risk-free investment and the tangent
portfolio.

• Every investor should invest in the tangent portfolio independent of his or her
taste for risk.
Identifying the Tangent Portfolio (cont'd)
• An investor’s preferences will determine only how much to
invest in the tangent portfolio versus the risk-free
investment.
• Conservative investors will invest a small amount in the tangent
portfolio.
• Aggressive investors will invest more in the tangent portfolio.
• Both types of investors will choose to hold the same portfolio of
risky assets, the tangent portfolio, which is the efficient portfolio.
Efficient Portfolio and Required Returns
• Portfolio Improvement: Beta and the Required Return
• If you were to purchase more of investment i by borrowing, you would earn
the expected return of i minus the risk-free return. Thus adding i to the
portfolio P will improve our Sharpe ratio if:

E[RP ]  rf
E [Ri ]  rf  SD(Ri )  Corr (Ri ,RP ) 
SD(RP )
Additional return Incremental volatility
from investment i from investment i Return per unit of volatilty
available from portfolio P
Efficient Portfolio and Required Returns
• Portfolio Improvement: Beta and the Required Return
• Beta of Portfolio i with Portfolio P

SD(Ri )  Corr (Ri ,RP ) Corr (Ri ,RP )

P
i  
SD(RP ) Var (RP )
Efficient Portfolio and Required Returns
• Portfolio Improvement: Beta and the Required Return
• Increasing the amount invested in i will increase the Sharpe ratio of portfolio
P if its expected return E[Ri] exceeds the required return ri , which is given by:

ri  rf    (E[ RP ]  rf )
P
i
Efficient Portfolio and Required Returns
• Portfolio Improvement: Beta and the Required Return
• Required Return of i
• The expected return that is necessary to compensate for the risk investment i will
contribute to the portfolio.
Expected Returns
and the Efficient Portfolio
• Expected Return of a Security
E[ Ri ]  ri  rf   i
eff
 (E[ Reff ]  rf )

• A portfolio is efficient if and only if the expected return of every available

security equals its required return.
The Capital Asset Pricing Model
• The Capital Asset Pricing Model (CAPM) allows us to identify the
efficient portfolio of risky assets without having any knowledge of
the expected return of each security.

• Instead, the CAPM uses the optimal choices investors make to

identify the efficient portfolio as the market portfolio, the portfolio
of all stocks and securities in the market.
The CAPM Assumptions
• Three Main Assumptions

• Assumption 1
• Investors can buy and sell all securities at competitive market prices
(without incurring taxes or transactions costs) and can borrow and lend at
the risk-free interest rate.
The CAPM Assumptions (cont'd)
• Three Main Assumptions
• Assumption 2
• Investors hold only efficient portfolios of traded securities—portfolios that
yield the maximum expected return for a given level of volatility.
The CAPM Assumptions (cont'd)
• Three Main Assumptions
• Assumption 3
• Investors have homogeneous expectations regarding the volatilities,
correlations, and expected returns of securities.
• Homogeneous Expectations
• All investors have the same estimates concerning future investments and returns.
Capital Asset Pricing Model - CAPM

CAPM enables quantification of Risk of Asset and its Cost

Value Maximising Investor will diversify only that risk for which it will
demand risk premium as it non-diversifiable i.e.– systematic risk

Risk due macro factors

Beta is measure of Systematic Risk

Linear Regression of Asset Return over Market Return due same
holding period
Capital Asset Pricing Model – CAPM
Main Results
Beta tell relationship between expected return on asset and
systematic risk is linear

CAPM measures relationship between risk and expected return, when

markets for risky asset is in equilibrium

Not all risk affect equilibrium expected returns

Only those risk that cannot be diversified away

Capital Market Line
• Line on mu-sigma space, which combines risk free asset with risky
asset portfolio – Capital Market Line

• Under above assumptions, all investors will chose same portfolio of

risky asset which gives highest Sharpe Ratio

• They may assign different portfolio weights to optimal risky asset and
risk free asset
CORE CURRICULUM
The CAPM’s Security Market Line
Market Portfolio- Tangency Portfolio
• Portfolio with highest attainable Sharpe ratio

• There is no way to improve its risk adjusted return by holding more or

less of given asset

• Market portfolio is Tangency Portfolio

CORE CURRICULUM
The Business Risk Premium as a Weighted
Average of Debt and Equity Risk Premium
Optimal Investing: The Capital Market Line
• When the CAPM assumptions hold, an optimal portfolio is a
combination of the risk-free investment and the market portfolio.
• When the tangent line goes through the market portfolio, it is called the
capital market line (CML).
Optimal Investing:
The Capital Market Line (cont'd)
• The expected return and volatility of a capital market line portfolio
are:
E [RxCML ]  (1  x)rf  xE[RMkt ]  rf  x(E [RMkt ]  rf )

SD(RxCML )  xSD(RMkt )
The Capital Market Line
Determining the Risk Premium
• Market Risk and Beta
• Given an efficient market portfolio, the expected return of an investment is:

E[Ri ]  ri  rf  iMkt (E[RMkt ]  rf )

Risk premium for security i

• The beta is defined as:

Volatility of i that is common with the market

SD(Ri )  Corr (Ri ,RMkt ) Cov(Ri ,RMkt )

 i
Mkt
 i  
SD(RMkt ) Var (RMkt )
• Problem
• Assume the risk-free return is 5% and the market portfolio has an
expected return of 12% and a standard deviation of 44%.
• ATP Oil and Gas has a standard deviation of 68% and a correlation
with the market of 0.91.
• What is ATP’s beta with the market?
• Under the CAPM assumptions, what is its
expected return?
• Solution
SD(Ri )  Corr (Ri ,RMkt ) (.68)(.91)
i    1.41
SD(RMkt ) .44

E[Ri ]  rf  iMkt (E[RMkt ]  rf )  5%  1.41(12%  5%)  14.87%

The Security Market Line
• There is a linear relationship between a stock’s beta and its expected
return

• . The security market line (SML) is graphed as the line through the
risk-free investment and the market.
• According to the CAPM, if the expected return and beta for individual
securities are plotted, they should all fall along the SML.
Capital Market Line and Security Market Line
 Capital Market Line and the Security Market Line, panel (a)

(a) The CML depicts

portfolios combining
the risk-free
investment and the
efficient portfolio, and
shows the highest
expected return that
we can attain for each
level of volatility.
(b) According to the
CAPM, the market
portfolio is on the CML
and all other stocks
and portfolios contain
diversifiable risk and lie
to the right of the CML,
as illustrated for Exxon
Mobil (XOM).
Capital Market Line and the Security Market Line, panel (b)

(b) The SML shows the

expected return for each
security as a function of its
beta with the market.
According to the CAPM, the
market portfolio is efficient,
so all stocks and portfolios
should lie on the SML.
The Security Market Line (cont'd)
• Beta of a Portfolio
• The beta of a portfolio is the weighted average beta of the securities in the
portfolio.

Cov(RP ,RMkt ) 
Cov  i xi Ri ,RMkt  Cov(Ri ,RMkt )
P 
Var (RMkt )

Var (RMkt )
  i xi Var (RMkt )
  x
i i i
• Problem
• Suppose the stock of the 3M Company (MMM) has a beta of 0.69 and the
beta of Hewlett-Packard Co. (HPQ) stock is 1.77.
• Assume the risk-free interest rate is 5% and the expected return of the market
portfolio is 12%.
• What is the expected return of a portfolio of 40% of 3M stock and 60%
Hewlett-Packard stock, according to the CAPM?
• Solution
 P   i xi i  (.40)(0.69)  (.60)(1.77)  1.338

E[Ri ]  rf   i
Mkt
(E[RPortfolio ]  rf )

E[Ri ]  5%  1.338(12%  5%)  14.37%

Summary of the Capital Asset Pricing Model
• The market portfolio is the efficient portfolio.
• The risk premium for any security is proportional to its beta with the
market.
12.1 The Equity Cost of Capital
• The Capital Asset Pricing Model (CAPM) is a practical way to estimate.
• The cost of capital of any investment opportunity equals the
expected return of available investments with the same beta.
• The estimate is provided by the Security Market Line equation:

ri =rf + i  (E[RMkt ]-rf )

Risk Premium for Security i
Textbook Example 12.1
Textbook Example 12.1 (cont'd)
• Problem
• Suppose you estimate that Wal-Mart’s stock has a volatility of 16.1% and a
beta of 0.20. A similar process for Johnson & Johnson yields a volatility of
13.7% and a beta of 0.54.

• Q1. Which stock carries more total risk?

• Q2. Which has more market risk?

• Q3. If the risk-free interest rate is 4% and you estimate the market’s expected
return to be 12%, calculate the equity cost of capital for Wal-Mart and
Johnson & Johnson.
• Q4. Which company has a higher cost of equity capital?
Alternative Example 12.1 (cont'd)
• Solution
• Total risk is measured by volatility; therefore, Wal-Mart stock has more total
risk than Johnson & Johnson. Systematic risk is measured by beta. Johnson &
Johnson has a higher beta, so it has more market risk than Wal-Mart. Given
Johnson & Johnson’s estimated beta of 0.54, we expect the price for Johnson
& Johnson’s stock to move by 0.54% for every 1% move of the market.
Alternative Example 12.1 (cont'd)
• Solution (cont’d)
• Therefore, Johnson & Johnson’s risk premium will be 0.54 times the risk
premium of the market, and Johnson & Johnson’s equity cost of capital (from
Eq. 12.1) is

rJNJ = 4% + 0.54 × (12% − 4%) = 4% + 4.32% = 8.32%

Alternative Example 12.1 (cont'd)
• Solution (cont’d)
• Wal-Mart has a lower beta of 0.20. The equity cost of capital for Wal-Mart is
rWMT= 4% + 0.20 × (12% − 4%) = 4% + 1.6% = 5.6%

• Because market risk cannot be diversified, it is market risk that determines

the cost of capital; thus Johnson & Johnson has a higher cost of equity capital
than Wal-Mart, even though it is less volatile.
Beta Estimation
• Estimating Beta from Historical Returns
• Recall, beta is the expected percent change in the excess return of the
security for a 1% change in the excess return of the market portfolio.
• Consider Cisco Systems stock and how it changes with the market portfolio.
Beta Estimation

• Researchers have shown that the best measure of the risk of a security
in a large portfolio is the beta () of the security.
• Beta measures the responsiveness of a security to movements in the
market portfolio (i.e., systematic risk).

Cov(Ri,RM )
i 
 (RM )
2
Estimating with Regression

Security Returns
Slope = i
Return on
market %

Ri = a i + iRm + ei
The Formula for Beta
Cov(Ri,RM )  (Ri )
i  
 (RM )
2
 (RM )
Clearly, your estimate of beta will depend upon your
choice of a proxy for the market portfolio.


Relationship Between Risk and Expected
Return (CAPM)
• Expected Return on the Market:
R M  RF  Market Risk Premium
 Expected return on an individual security:

R i  RF  β i  ( R M  RF )

Market Risk Premium

This applies to individual securities held within

well-diversified portfolios.
Expected Return on a Security
• This formula is called the Capital Asset Pricing Model (CAPM):

R i  RF  i  (R M  RF )
Expected
Risk- Beta of the Market risk
return on = + ×
free rate security premium
a security

◦ Assume i = 0, then the expected return is RF.

◦ Assume i = 1, then 𝑅𝑖 = 𝑅𝑀
Monthly Returns for Cisco Stock and for the S&P 500, 2000-2012
Scatterplot of Monthly Excess Returns for Cisco Versus the S&P 500, 2000-2012
Beta Estimation (cont'd)
• Estimating Beta from Historical Returns
• As the scatterplot on the previous slide shows, Cisco tends to be up when the
market is up, and vice versa.
• We can see that a 10% change in the market’s return corresponds to about a
20% change in Cisco’s return.
• Thus, Cisco’s return moves about two for one with the overall market, so Cisco’s beta is
about 2.
12.3 Beta Estimation (cont'd)
• Estimating Beta from Historical Returns
• Beta corresponds to the slope of the best-fitting line in the plot of the
security’s excess returns versus the market excess return.
Using Linear Regression
• Linear Regression
• The statistical technique that identifies the best-fitting line through a set of
points.
(Ri  rf )  a i  i (RMkt  rf )   i

• αi is the intercept term of the regression.

• βi(RMkt – rf) represents the sensitivity of the stock to
market risk. When the market’s return increases by 1%, the security’s return increases by
βi%.
• εi is the error term and represents the deviation from the best-fitting line and is zero on
average.
Using Linear Regression (cont'd)
• Linear Regression
• Since E[εi] = 0:

E[Ri ]  rf  i ( E[RMkt ]  rf )  ai
Expected return for i from the SML Distance above / below the SML

• αi represents a risk-adjusted performance measure for the historical returns.

• If αi is positive, the stock has performed better than predicted by the CAPM.
• If αi is negative, the stock’s historical return is below the SML.
Using Linear Regression (cont'd)
• Linear Regression
• Given data for rf , Ri , and RMkt , statistical packages for linear regression can
estimate βi.
• A regression for Cisco using the monthly returns for 1996–2009 indicates the estimated
beta is 1.80.
• The estimate of Cisco’s alpha from the regression is 1.2%.
Relationship Between Risk & Return - I

Expected return
R i  RF  i  (R M  RF )

RM

 RF

1.0 
Relationship Between Risk & Return – II

Expected return
13.5%

3%
 1.5 

i  1.5 RF  3% R M  10%
 R i  3 %  1 .5  (10 %  3 %)  13 .5 %
Using a Levered Firm as a Comparable for a
Project’s Risk
Levered and Unlevered Beta
• Asset (unlevered) cost of capital
• Expected return required by investors to hold the firm’s underlying assets.
• Weighted average of the firm’s equity and debt costs of capital

E D
rU = rE + rD
E+D E+D
Unlevered Beta
• Asset (unlevered) beta
E D
βU = βE + βD
E+D E+D
Problem

• Q1. Calculate Unlevered Beta

• Q2. Calculate Levered Beta for new target?

The Weighted Average Cost of Capital
• Weighted Average Cost of Capital (WACC)
E E
rwacc = rE + rD ( 1-τC )
E+D E+D

• Given a target leverage ratio:

D
rwacc =rU - τC rD
E+D
The Weighted Average Cost of Capital (cont’d)
• How does rwacc compare with rU?
• Unlevered cost of capital (or pretax WACC) is:
• Expected return investors will earn by holding the firm’s assets
• In a world with taxes, it can be used to evaluate an all-equity project with the same risk
as the firm.
• In a world with taxes, WACC is less than the expected return of the firm’s
assets.
• With taxes, WACC can be used to evaluate a project with the same risk and the same
financing as the firm.
That’s it for the day !