Risk and Return in Practice: Problems and Questions 1. In December 1995, Boise Cascade's stock had a beta of 0.95.

The treasury bill rate at the time was 5.8%, and the treasury bond rate was 6.4%. The historical risk premium of the Standard&Poor index is 5.5%. The firm had debt outstanding of $ 1.7 billion and a market value of equity of $ 1.5 billion; the corporate marginal tax rate was 36%. a. Estimate the expected return on the stock for a short term investor in the company. b. Estimate the expected return on the stock for a long term investor in the company. c. Estimate the cost of equity for the company. 2. Boise Cascade also had debt outstanding of $ 1.7 billion and a market value of equity of $ 1.5 billion; the corporate marginal tax rate was 36%. The historical risk premium of the Standard&Poor index is 5.5%. a. Assuming that the current beta of 0.95 for the stock is a reasonable one, estimate the unlevered beta for the company. b. How much of the risk in the company can be attributed to business risk and how much to financial leverage risk? 3. Biogen Inc., as biotechnology firm, had a beta of 1.70 in 1995. It had no debt outstanding at the end of that year. a. Estimate the cost of equity for Biogen, if the treasury bond rate is 6.4% and the expected yield of S&P index is 12%. b. What effect will an increase in long term bond rates to 7.5% have on Biogen's cost of equity? c. How much of Biogen's risk can be attributed to business risk? 4. Genting Berhad is a Malaysian conglomerate, with holding in plantations and tourist resorts. The beta estimated for the firm, relative to the Malaysian stock exchange, is 1.15, and the long term government borrowing rate in Malaysia is 11.5%. The Malaysian Stock Market risk premium is expected to 7,5%. a. Estimate the expected return on the stock. b. If you were an international investor, what concerns, if any, would you have about using the beta estimated relative to the Malaysian Index? If you do, how would you modify the beta? 5. You have just done a regression of monthly stock returns of HeavyTech Inc., a manufacturer of heavy machinery, on monthly market returns over the last five years and come up with the following regression: RHeavyTech = 0.5% + 1.2 RM

The current T.Bill rate is 3% (It was 5% one year ago). The stock is currently selling for $50, down $4 over the last year, and has paid a dividend of $2 during the last year and expects to pay a dividend of $2.50 over the next year. The NYSE composite has gone down 8% over the last year, with a dividend yield of 3%. The risk premium of market is supposed to be 8,5%. a. What is the expected return on HeavyTech over the next year? b. What would you expect HeavyTech's price to be one year from today? c. What would you have expected HeavyTech's stock returns to be over the last year? d. What were the actual returns on HeavyTech over the last year? e. HeavyTech has $100 million in equity and $ 50 million in debt. It plans to issue $50 million in new equity and retire $50 million in debt. Estimate the new beta, if HeavyTech Inc. has a tax rate of 40%. 6. Safecorp, which owns and operates grocery stores across the United States, currently has $50 million in debt and $100 million in equity outstanding. Its stock has a beta of 1.2. It is planning a leveraged buyout , where it will increase its debt/equity ratio of 8. If the tax rate is 40%, what will the beta of the equity in the firm be after the LBO? 7. Novell, which had a market value of equity of $2 billion and a beta of 1.50, announced that it was acquiring WordPerfect, which had a market value of equity of $ 1 billion, and a beta of 1.30. Neither firm had any debt in its financial structure at the time of the acquisition, and the corporate tax rate was 40%. a. Estimate the beta for Novell after the acquisition, assuming that the entire acquisition was financed with equity. b. Assume that Novell had to borrow the $ 1 billion to acquire WordPerfect. Estimate the beta after the acquisition. 8. You are analyzing the beta for Hewlett Packard and have broken down the company into four broad business groups, with market values and betas for each group. Business Group Mainframes Personal Computers Software Printers Market Value of Equity $ 2.0 billion $ 2.0 billion $ 1.0 billion $ 3.0 billion Beta 1.10 1.50 2.00 1.00

a. Estimate the beta for Hewlett Packard as a company. Is this beta going to be equal to the beta estimated by regressing past returns on HP stock against a market index. Why or Why not?

b. If the treasury bond rate is 7.5% and the market risk premium is 5,5%, estimate the cost of equity for Hewlett Packard. Estimate the cost of equity for each division. Which cost of equity would you use to value the printer division? c. Assume that HP divests itself of the mainframe business and pays the cash out as a dividend. Estimate the beta for HP after the divestiture. (HP had $ 1 billion in debt outstanding. Hewlett Packards effective tax rate is 36%) 9. The following table summarizes the percentage changes in operating income, percentage changes in revenue and betas for four pharmaceutical firms. Firm PharmaCorp SynerCorp BioMed Safemed % Change in Revenue 27% 25% 23% 21% % Change in Operating Income 25% 32% 36% 40% Beta 1.00 1.15 1.30 1.40

a. Calculate the degree of operating leverage for each of these firms. b. Use the operating leverage to explain why these firms have different betas. 10. A prominent beta estimation service reports the beta of Comcast Corporation, a major cable TV operator, to be 1.45. The service claims to use weekly returns on the stock over the prior five years and the NYSE composite as the market index to estimate betas. You replicate the regression using weekly returns over the same period and arrive at a beta estimate of 1.60. How would you reconcile the two estimates? 11. Battle Mountain is a mining company, which mines gold, silver and copper in mines in South America, Africa and Australia. The beta for the stock is estimated to be 0.30. Given the volatility in commodity prices, how would you explain the low beta? 12. You have collected returns on AnaDone Corporation (AD Corp.), a large diversified manufacturing firm, and the NYSE index for five years: Year 1981 1982 1983 1984 1985 AD Corp 10% 5% -5% 20% -5% NYSE 5% 15% 8% 12% -5%

a. Estimate the intercept (alpha) and slope (beta) of the regression. b. If you bought stock in AD Corp. today how much would you expect to make as a return over the next year? [The six-month T.Bill rate is 6%] The market risk premium is supposed to be 8,5%.

c. Looking back over the last five years, how would you evaluate AD's performance relative to the market? (The riskfree rate during the period was also 6% on an annual basis) d. Assume now that you are an undiversified investor and that you have all of your money invested in AD Corporation. What would be a good measure of the risk that you are taking on? How much of this risk would you be able to eliminate if you diversify? e. AD is planning to sell off one of its divisions. The division under consideration has assets which comprise half of the book value of AD Corporation, and 20% of the market value. Its beta is twice the average beta for AD Corp (before divestment). What will the beta of AD Corporation be after divesting this division? 13. You run a regression of monthly returns of Mapco Inc, an oil and gas producing firm, on the S&P 500 index and come up with the following output for the period 1991 to 1995. Intercept of the regression = 0.06% X-coefficient of the regression = 0.46 Standard error of X-coefficient = 0.20 R squared = 5% There are 20 million shares outstanding, and the current market price is $ 2. The firm has $ 20 million in debt outstanding. (The firm has a tax rate of 36%) a. What would an investor in Mapco's stock require as a return, if the T.Bond rate is 6% and the market risk premium is 5,5%? b. What proportion of this firm's risk is diversifiable? c. Assume now that Mapco has three divisions, of equal size (in market value terms). It plans to divest itself of one of the divisions for $ 20 million in cash and acquire another for $ 50 million (It will borrow $ 30 million to complete this acquisition). The division it is divesting is in a business line where the average unlevered beta is 0.20, and the division it is acquiring is in a business line where the average unlevered beta is 0.80. What will the beta of Mapco be after this acquisition? 14. You have just run a regression of monthly returns of American Airlines (AMR) against the S&P 500 over the last five years. You have misplaced some of the output and are trying to derive it from what you have. a. You know the R squared of the regression is 0.36, and that your stock has a variance of 67%. The market variance is 12%. What is the beta of AMR? b. You also remember that AMR was not a very good investment during the period of the regression and that it did worse than expected (after adjusting for risk) by 0.39 % a

month for the five years of the regression. During this period, the average riskfree rate was 4.84%. What was the intercept on the regression? c. You are comparing AMR Inc. to another firm which also has an R squared of 0.48. Will the two firms have the same beta? If not, why not? 15. You have run a regression of monthly returns on Amgen, a large biotechnology firm, against monthly returns on the S&P 500 index, and come up with the following output Rstock = 3.28% + 1.65 RMarket R2= 0.20 The current one-year treasury bill rate is 4.8% and the current thirty-year bond rate is 6.4%, and the market risk premium is 8,5%. The firm has 265 million shares outstanding, selling for $ 30 per share. i. What is the expected return on this stock over the next year? ii. Would your expected return estimate change if the purpose was to get a discount rate to analyze a thirty-year capital budgeting project? iii. An analyst has estimated, correctly, that the stock did 51.10% better than expected, annually, during the period of the regression. Can you estimate the annualized riskfree rate that she used for her estimate? iv. The firm has a debt/equity ratio of 3%, and faces a tax rate of 40%. It is planning to issue $2 billion in new debt and acquire a new business for that amount, with the same risk level as the firm's existing business. What will the beta be after the acquisition? 16. You have just run a regression of monthly returns on MAD Inc., a newspaper and magazine publisher, against returns on the S&P 500, and arrived at the following result RMAD = - 0.05% + 1.20 RS&P The regression has an R-squared of 22%. The current T.Bill rate is 5.5% and the current T.Bond rate is 6.5%. The riskfree rate during the period of the regression was 6%.. Answer the following questions relating to the regression a. Based upon the intercept, you can conclude that the stock did A. 0.05% worse than expected on a monthly basis, during the regression. B. 0.05% better than expected on a monthly basis during the period of the regression C. 1.25% better than expected on a monthly basis during the period of the regression. D. 1.25% worse than expected on a monthly basis during the period of the regression.

E. None of the above. (1 point) b. You now realize that MAD Inc went through a major restructuring at the end of last month (which was the last month of your regression), and made the following changes The firm sold off its magazine division, which had an unlevered beta of 0.6, for $ 20 million. o It borrowed an additional $ 20 million, and bought back stock worth $ 40 million.
o

After the sale of the division and the share repurchase, MAD Inc. had $ 40 million in debt and $ 120 million in equity outstanding. If the firm's tax rate is 40%, re-estimate the beta, after these changes. 17. Time Warner Inc., the entertainment conglomerate, has a beta of 1.61. Part of the reason for the high beta is the debt left over from the leveraged buyout of Time by Warner in 1989, which amounted to $10 billion in 1995. The market value of equity at Time Warner in 1995 was also $ 10 billion. The marginal tax rate was 40%. a. Estimate the unlevered beta for Time Warner. b. Estimate the effect of reducing the debt ratio by 10% each year for the next two years on the beta of the stock. 18. Chrysler, the automotive manufacturer, had a beta of 1.05 in 1995. It had $ 13 billion in debt outstanding in that year, and 355 million shares trading at $ 50 per share. The firm had a cash balance of $ 8 billion at the end of 1995. The marginal tax rate was 36%. a. Estimate the unlevered beta of the firm. b. Estimate the effect of paying out a special dividend of $ 5 billion on this unlevered beta. c. Estimate the beta for Chrysler after the special dividend. 19. You are trying to estimate the beta of a private firm that manufactures home appliances. You have managed to obtain betas for publicly traded firms that also manufacture home appliances. Firm Black & Decker Fedders Corp. Maytag Corp. National Presto Whirlpool Beta 1.40 1.20 1.20 0.70 1.50 Debt $ 2,500 $5 $ 540 $8 $ 2900 MV of Equity $ 3,000 $ 200 $ 2250 $ 300 $ 4000

The private firm has a debt equity ratio of 25%, and faces a tax rate of 40%. The publicly traded firms all have marginal tax rates of 40%, as well.

a. Estimate the beta for the private firm. b. What concerns, if any, would you have about using betas of comparable firms? 20. As the result of stockholder pressure, RJR Nabisco is considering spinning off its food division. You have been asked to estimate the beta for the division, and decide to do so by obtaining the beta of comparable publicly traded firms. The average beta of comparable publicly traded firms is 0.95, and the average debt/equity ratio of these firms is 35%. The division is expected to have a debt ratio of 25%. The marginal corporate tax rate is 36%. a. What is the beta for the division? b. Would it make any difference if you knew that RJR Nabisco had a much higher fixed cost structure than the comparable firms used here? 21. Southwestern Bell, a phone company, is considering expanding its operations into the media business. The beta for the company at the end of 1995 was 0.90, and the debt/equity ratio was 1. The media business is expected to be 30% of the overall firm value in 1999, and the average beta of comparable firms is 1.20; the average debt/equity ratio for these firms is 50%. The marginal corporate tax rate is 36%. a. Estimate the beta for Southwestern Bell in 1999, assuming that it maintains its current debt/equity ratio. b. Estimate the beta for Southwestern Bell in 1999, assuming that it decides to finance its media operations with a debt/equity ratio of 50%. 22. The chief financial officer of Adobe Systems, a growing software manufacturing firm, has approached you for some advice regarding the beta of his company. He subscribes to a service which estimates Adobe System's beta each year, and he has noticed that the beta estimates have gone down every year since 1991 - 2.35 in 1991 to 1.40 in 1995. He would like the answers to the following questions a. Is this decline in beta unusual for a growing firm? b. Why would the beta decline over time? c. Is the beta likely to keep decreasing over time? 23. You are analyzing Tiffany's, an upscale retailer, and find that the regression estimate of the firm's beta is 0.75; the standard error for the beta estimate is 0.50. You also note that the average unlevered beta of comparable specialty retailing firms is 1.15. a. If Tiffany's has a debt/equity ratio of 20%, estimate the beta for the company based upon comparable firms. (The tax rate is 40%) b. Estimate a range for the beta from the regression. c. How would you reconcile the two estimates? Which one would you use in your analysis?

Solutions Problem 1 a. Expected Return to Short-term Investor = 5.8% + 0.95 (8.5%) = 13.88% (I am using the historical premium of 8.5% to estimate expected returns) b. Expected Return to Long-term Investor = 6.4% + 0.95 (5.5%) = 11.63% c. I would use the expected return of 11.63% as the cost of equity Problem 2 a. Unlevered Beta = 0.95 / (1 + (1- 0.36) (1700/1500)) = 0.55 b. The beta of 0.95 can be broken down into business risk (0.55) and financial risk (0.40). Problem 3 a. Cost of Equity = 6.40% + 1.70 (5.5%) = 15.75% b. If the long term bond rate rises to 7.5%, the cost of equity will rise by 1.1%. c. Since the firm had no debt, all of the risk can be attributed to business risk. Problem 4 a. Expected Return = 11.5% + 1.15 (7.50%) = 20.13% {I am using a premium of 7.50% for Malaysian stocks to reflect its higher risk.} b. This beta measures risk relative to a Malaysian index. For an international investor an more appropriate beta may be the one estimated relative to a global index. Problem 5 a. Expected Return = 3% + 1.2 (8.5%) = 13.20% b. Expected Price Appreciation = 13.20% - ($ 2.50 / $ 50) = 8.20% Expected Price one year from today = $ 50 (1.082) = 54.10 $ c. Expected Returns over last year = 5% + 1.20 (-5% - 5%) = -7.00% Returns on Market = -8% + 3% = -5% d. Actual Returns over last year = (50-54+2)/54 = -3.70% e. Unlevered Beta = 1.20 / (1+ (1-.4) (50/100)) = 0.923 If the firm issues $ 50 million in equity and retires debt, its beta will drop to 0.923 Problem 6 Unlevered Beta = 1.20 / (1 + (1-0.4) (50/100)) = 0.923076923 New Beta = 0.923 (1 + (1-0.4) (8)) = 5.35 Problem 7 a. Unlevered Beta for Novell = 1.50 ! Firm has no debt Unlevered Beta for WordPerfect = 1.30 ! Firm has no debt Unlevered Beta for Combined Firm = 1.50 (2/(2+1)) + 1.30 (1/(2+1)) = 1.43 This would be the beta of the combined firm if the deal is all-equity. b. If the deal is financed with debt, New Debt/Equity Ratio = 1/2 = 0.5 New Beta = 1.43 (1 + (1-.4) (0.5)) = 1.86 Problem 8 a. Beta for Hewlett Packard = 1.10 (2/8) + 1.50 (2/8) + 2.00 (1/8) + 1.00 (3/8) = 1.275 This beta may not be equal to the regression estimate of beta, because both of these are estimated with error b. Cost of Equity = 7.5% + 1.275 (5.5%) = 14.51%

Mainframes Cost of Equity = 7.5% + 1.10 (5.5%) = 13.55% Personal Computers Cost of Equity = 7.5% + 1.5(5.5%) = 15.75% Software Cost of Equity = 7.5% + 2 (5.5%) = 18.50% Printer Division's Cost of Equity = 7.5% + 1 (5.5%) = 13.00% To value the printer division, I would use a 13.00% cost of equity. c. Assuming that the leverage is equally distributed across the divisions, Division Beta Unlevered Beta Value of Equity Debt Firm Value Mainframes 1,10 1,019 2,00 0,25 2,25 PCs 1,50 1,389 2,00 0,25 2,25 Sofware 2,00 1,852 1,00 0,125 1,13 Printers 1,00 0,926 3,00 0,375 3,38 Unlevered Beta = 1.389 (2.25/6.75) + 1.852 (1.125/6.75) + 0.926 (3.375/6.75) = 1.235 New Debt/Equity Ratio = 1/5.75 New Levered Beta = 1.235 (1 + (1-.36) (1/5.75)) = 1.37 Problem 9 Firm %Revenue %OI Operating leverage Beta PharmaCorp 27% 25% 0,93 1,00 SynerCorp 25% 32% 1,28 1,15 BioMed 23% 36% 1,57 1,30 Safemed 21% 40% 1,90 1,40 b. Firms with high operating leverage also have high betas. Problem 10 Beta estimation services adjust betas towards one. It is possible that this adjustment is the reason for the difference between the regression beta (1.60) and the reported beta of 1.45. Problem 11 The beta reflects market risk and is estimated relative to a stock index. To the extent that commodity prices and stock prices are not highly positively correlated the low betas reflect the low market risk inherent in these stocks. I would expect these firms to have substantial firm-specific risk. Problem 12 Year AD 1981 10% 1982 5% 1983 -5% 1984 20% 1985 5%

NYSE 5% 15% -8% 12% -5%

a. Regression Results Returns on AD = 0.047 + 0.60 ( NYSE) The intercept is 4.7%; the beta is 0.60. b. Expected Return over next year = 6% + 0.60 (8.5%) = 11.10% c. Intercept = 4.70% Riskfree Rate (1-Beta) = 6% (1-0.60) = 2.40% Intercept - Riskfree Rate (1-Beta) = 4.7% - 2.4% = 2.30% On an annual basis, the stock did 2.3% better than expected.

d. If you were an undiversified investor, you would be exposed to all risk in AD; this can be measured in terms of the standard deviation in AD returns (9.08%). The R-squared of this regression is 45%; this suggests that 55% is diversifiable risk. e. Beta for divested division = 2 (0.60) = 1.20 1.20 (.2) + X (0.8) = 0.6 Solve for X, X = 0.36/.8 = 0.45 This is the beta after the divestiture, assuming that the cash is paid out and that the leverage is unaffected. Problem 13 a. Expected Return = 6% + 0.46 (5.5%) = 8.53% b. Proportion of the firm's risk that is diversifiable = 1 - R squared = 95% c. Existing Debt/Equity Ratio = 20/(20*2) = 50.00% Unlevered Beta for the firm = 0.46/(1+(1-.36) (.5)) = 0.35 Unlevered Beta of Firm without divested division 0.20 (20/60) + X (40/60) = 0.35 Solving for X, X = (0.35 - 0.0667)/(40/60) = 0.42 New Unlevered Beta with new division, 0.42 (40/90) + 0.80 (50/90) = 0.63 New Debt/Equity Ratio = (20 + 30)/40 = 1.25 New Levered Beta = 0.63 (1 + (1-.36) (1.25)) = 1.13 Problem 14 2 a. R squared = 2 * m / i2 Beta2 = (0.36*0.67)/0.12 = 2.01 Beta = 1.42 b. Jensen's alpha = Intercept - Riskfree Rate (1-Beta) -0.39% = Intercept - 0.39% (1-1.42) Monthly Riskfree Rate = (1.0484)1/12 - 1 = 0.39% Solving for the intercept, Intercept = -0.39% + 4,84% (1-1.42) = -2,41% c. The two firms might not have the same beta, because they might have different total variances.

Problem 15 a. Expected Return on the Stock over next year = 4.8% + 1.65 (8.5%) = 18.83% b. Yes, i would use the long term bond rate as my riskless rate. Expected Return on the Stock = 6.4% + 1.65 (5.5%) = 15.48% c. Monthly Jensen's Alpha = (1.51)1/12 - 1 = 3.49% 3.49% = 3.28% - Riskfree Rate (1-1.65) Solving for the riskless rate, Monthly Riskless Rate = 0.21%/(0.65) = 0.32% Annualized Riskless Rate = (1.0032)12 - 1 = 3.91% d. Unlevered Beta = 1.65 / (1 + (1-.4)(.03)) = 1.62 Market Value of Equity = 265 * $ 30 = 7,950.00 $ Existing Debt = 0.03 (7950) = 238.50 $ New Debt = $ 238.50 + $ 2000 = 2,238.50 $ New Levered Beta = 1.62 (1 + (1-.4) (2238.5/7950) = 1.89

Problem 16 a. Intercept - Riskfree Rate (1-Beta) = -0.05% - 0.49% (1-1.20) = 0.05% Monthly Riskfree Rate = 1.06(1/12) - 1 = 0.49% The stock did 0.05% better than expected during the period of the regression. b. Debt before restructuring = $ 40 million - $ 20 million = 20.00 $ Equity before restructuring = $ 120 + $ 40= 160.00 $ Debt/Equity Ratio before restructuring = 20/160 = 12.50% Unlevered Beta before restructuring = 1.20 / (1+(1-.4)(.125)) = 1.12 Unlevered Beta after the divisional sale, 0.6(20/180) + X (160/180) = 1.12 Solving for X, Unlevered Beta after divisional sale = 1.19 New Debt/Equity Ratio after restructuring = 40/120 = 0.333333333 New Beta = 1.19 (1 + (1-.4) (0.33)) = 1.43 Problem 17 a. Unlevered Beta = 1.61 / (1+(1-.4) (10/10)) = 1.01 b. Estimated Debt Ratios Year Debt Ratio D/E Beta 1 40% 0,67 1,41 2 30% 0,42871 1,27 Problem 18 a. Unlevered Beta = 1.05 / (1 + (1-.36)(13000/(355*50)) = 0.71 b. With special dividend, Debt/Equity Ratio = 13000/(355*50-5000) = 1.02 Assuming that the beta of cash is 0, Value of Firm before dividend = 13000 + 355*50 = 30,750.00 $ 0 (8000/30750) + X (22750/30750) = 0.71 Solving for X, X = 0.96 The unlevered beta after the special dividend will be 0.96. c. New Beta after the special dividend = 0.96 (1+(1-.36)(1.02) = 1.59 Problem 19 Company Beta Debt Equity D/E Black&Decker 1,40 2500 3000 83,33% Fedders 1,20 5 200 2,50% Maytag 1,20 540 2250 24,00% National Presto 0,70 8 300 2,67% Whirlpool 1,50 2900 4000 72,50% Average 1,20 37,00% Unlevered beta = 1.20 / (1+(1-.4)(.37)) = 0.98 a. Beta for private firm = 0.98 (1+ (1-.4) (.25)) = 1.13 b. The firms might not be directly comparable in terms of business mix. Furthermore, the risk of a firm may be affected by its size; if the private firm is much smaller, this beta might not adequately reflect its risk. Finally, this beta reflects only market risk; the private firm may care about firm-specific risk as well. Problem 20

a. Unlevered Beta for Food Business = 0.95/ (1 + (1-.36) (.35)) = 0.78 Beta for Food Division = 0.78 (1 + (1-.36) (.25)) = 0.90 b. Yes. The higher fixed cost structure would lead me to use a higher unlevered beta for Nabisco. Problem 21 a. Unlevered Beta of phone business = 0.90 / (1+0.64*1) = 0.55 Unlevered Beta of media business = 1.20 / (1 + 0.64*.5) = 0.91 Unlevered Beta in 1999 = 0.7 (0.55) + 0.3 (0.91) = 0.66 Beta in 1999 = 0.66 (1 + (1-.36) (1.00)) = 1.08 b. If it finances its media operations with a 50% D/E ratio, Overall Debt Ratio = 1 (.7) + .5 (.3) = 0.85 Beta with this debt ratio = 0.66 (1 + 0.64 (0.85)) = 1.02 Problem 22 a. No, it is not unusual. As firms grow and become larger, they generally become more diversified and less risky. b. I would expect it to continue since Adobe still has a beta well above one. c. I would expect it to stop as the beta approaches one. Problem 23 a. Unlevered Beta of comparable firms = 1.15 Beta for Tiffany's based on comparable firms = 1.15 (1+0.6*.2) = 1.29 b. Range for beta from regression With one standard error : 0.25 - 1.25 c. The regression estimate is very noisy. It is entirely possible that both of these estimates are from the same distribution; I would trust the "comparable firm" estimate more.

Discussion Issues and Derivations

1. A Derivation of the Capital Asset Pricing Model I. Establish the Objects of Choice: Mean versus Variance Theme: Investors are risk averse. They measure reward using expected return and risk using variance. Underlying assumptions: The mean-variance assumption can hold only if (a) all investors have quadratic utility function or (b) returns are normally distributed. Implication: Portfolio A with higher expected return and the same variance as portfolio B will be preferred to B II. Benefits of Diversification For any desired level of risk (s) there exists a portfolio of several assets which yields a higher expected return than any individual security E(Rp) = wi E(Ri) 2p = wi wj Covij Efficient portfolios: maximize returns for any level of risk. Implications: (a) Everybody should diversify (b) Investors should try to identify and hold efficient portfolios (c) This method has very heavy computational requirements. III. The Single Index Model: The Logical Limit of Diversification Assumptions: (a) Riskfree lending and borrowing (b) Markets which are frictionless there are no transactions costs (c)Homogeneous expectations Implications: (1) The risky portfolio than when combined with the riskless asset

maximizes returns is the market portfolio. (2) Everybody holds some combination of the market portfolio and the risky asset. How much of each is held will be a function of the investor's risk aversion.(3) Since all investors hold the same market portfolio it must contain all assets in the economy in proportion to their value. IV. The Risk of an Individual Asset Step 1: Individuals diversify and hold portfolios Step 2: The risk of a security is the risk it adds to the portfolio Step 3: Everybody holds the market portfolio Step 4: The risk of a security is the risk that it adds to the market portfolio. Step 5: The covariance between an asset "i" and the market portfolio (Covim) is a measure of this added risk. The higher the covariance the higher the risk. Step 6: This measure can be standardized by dividing by the market variance. b = Covim/ 2m.
Variants of the Capital Asset Pricing Model I. No Riskless Asset Basis: If no riskless asset exists investors can use a portfolio of risky assets which is uncorrelated with the market portfolio instead as the riskless asset. This portfolio is called the zero-beta portfolio. Properties of the Zero-beta portfolio (1) Of all the the zero-beta portfolios this has the minimum variance (2) The separation principle applies here with the two portfolios, the market portfolio and the zero-beta portfolio, i.e. all investors hold combinations of the two. (3) The expected return on any security can be expressed as a linear function of its beta. E(Ri) = E(Rz) + (E(Rm) - E(Rz)) where E(Rz) is the expected return on a zero beta portfolio II. Riskless Lending but no Riskless Borrowing Basis: (a) There is a piecewise linear relationship between expected return and beta for efficient portfolios. (b) Efficient portfolios with the riskfree asset lie along the segment RfT and those containing only risky assets lies along the segment TMC. III. Existence of Non-Marketable Assets (such as Human Capital) The separation principle still holds but, (a) Investors hold different portfolios of risky assets depending upon the portfolios of nonmarketable assets that they possess. (b) The market price of risk includes the variance of the market and the covariance between the market portfolio and the portfolio of non-marketable assets IV. Existence of Taxes Model: The model considers differential taxes on dividends and capital gains in a one-period context where investors maximize their one-period returns. The final model for expected return has a dividend component E(Ri) = a + i (E(Rm) - Rf) + c (di - Rf) where di = Dividend yield on asset i Rf = After-tax riskfree rate V. Existence of Heterogeneous Expectations and Information Model: To get strong conclusions we have to assume that all investors have a certain class of utility functions (Constant Absolute risk aversion) and complete markets (At least as many independent securities as states).

 Testing the CAPM: Issues and Discussion Issue 1: The CAPM can never be tested because the market portfolio can never be observed Central to the CAPM is the concept of a market portfolio which includes every asset in the economy. To test the CAPM therefore one has to observe and be able to measure this efficient market portfolio. If one cannot do so one cannot test the CAPM. One cannot use of an inefficient portfolio like the S&P 500 or the NYSE 2000 or even every stock in the economy to estimate betas and test for linearity (like all the studies have done) because (a) The betas measured against an inefficient portfolio are meaningless measures and cannot be used to accept or reject the CAPM which is really a theory about betas measured against the efficient market portfolio (b) For every inefficient portfolio there exists a set of betas which will satisfy the linearity condition. Issue 2: The CAPM is difficult to test on individual assets The noisiness in beta estimates and the fact that the CAPM yields expected returns for individual assets over the long term makes it difficult to test the CAPM by trying to relate expected returns on individual assets (such as stocks) to their betas. What most tests of the CAPM do instead is to look at portfolios of stocks, based upon betas, and then compare these betas to expected returns in the next time period. More on Factor Analysis and the Arbitrage Pricing Model Central to applying the arbitrage pricing model is the use of a factor analysis. In a typical factor analysis, we begin with pricing data on a large number of assets over very long time periods. In the factor analysis, we look for factors that seem to move prices on large numbers of assets in unison. To prevent factors from being double counted, we ensure that the factors that emerge are independent of each other. While all of this occurs behind the screen of the factor analysis, what emerges as output from the analysis includes: (a) the number of common factors that appeared to affect asset prices over the period for which the data is available (b) the betas of each asset relative to each factor, again using the same data (c) the "risk premiums" associated with each factor These factor betas and factor premiums are then used, in conjunction with a riskfree rate to get an expected return for an asset. Estimating the Macro Economic Factors in a Multi-Factor Model Once the number of factors have been identified in an arbitrage pricing model, the time series behavior of each factor can be derived from the factor analysis. The search then begins for macro economic factors that exhibit the same time series behavior. Once macro economic factors have been matched up with the unnamed factors in the factor analysis, the betas of each asset are re-estimated against the identified macro economic factors. The beta estimation may be done by running a multiple regression of stock returns (for each stock) against changes in macro economic variables (such as interest rates, inflation rates and GNP growth) over time. The coefficients on these regressions yield the betas, and risk premiums can be estimated also from the historical data. Building a Regression Model Generally, regression models begin with the cross sectional differences in returns across stocks at any point in time, and try to explain these differences using differences on measurable financial characteristics of the firms issuing these assets. As an example, Fama and French, in their much quoted study, used differences in market capitalization and price to book ratios to explain differences in returns across stocks. The more difficult question is deciding which financial variables to use in explaining returns. The best place to start is to look at the empirical evidence that has been accumulated over time on market efficiency and the CAPM. This evidence suggests that

- Low market capitalization stocks seem to earn higher returns, on average, than high market capitalization stocks - Low PE, PBV and PS ratio stocks seem to earn higher returns, on average, than high PE, PBV and PS ratio stocks - High dividend yield stocks seem to earn higher returns, on average, than low dividend yield stocks While the initial regression may include all of these variables, many of these variables tend to be correlated with each other. Thus, low PE stocks tend to also be low PBV ratio stocks which pay high dividends. In the interests of efficiency (and to prevent problems in the regression from independent variables being correlated with each other), it makes sense to use the measure that is most highly correlated with returns and drop the others. Thus, the use of price to book value ratios by Fama and French. Why not use bond betas to arrive at the cost of debt? Given that we use stock betas to arrive at expected returns for stocks, the question may arise as to why we do not use bond betas to get expected returns for bonds. The reason lies in the absence or presence of symmetry in returns for each of these asset classes. Stocks, which have potentially unlimited upside potential as well as significant downside potential, have much more symmetric returns than bonds. Thus, they tend to fit in much more cleanly into the mean-variance framework than do bonds. Corporate bonds have some upside potential, but it is limited by the fact that bonds can at best become default-free. Thus, the upside potential for a AA rated bond is fairly limited. Consequently, the risk measure that we have to use has to be a downside risk measure, which is what default risk and ratings measure. Clearly, the lower the rating of a bond, the greater the upside potential, and thus, the greater the likelihood that we can estimate bond betas and expected returns on them. For a junk bond, for instance, it may be possible to estimate a beta like a stock beta and get an expected return from it. Credit Scores as Alternatives to Bond Ratings Bond ratings are a tool that we use to measure default risk and arrive at a cost of debt. Lenders (such as banks) have historically used credit scores as a measure of default risk, especially when lending to individuals and private businessess. A credit score is derived by measuring how a borrower scores on a variety of measures, which over time have been correlated with default risk. Morningstar

Operating Risk
In investing, as in life, risk comes in many guises. A journal entry I wrote in December, which looked at some commonalties among great managers, touched briefly on the idea of separating a company's operating risk from its stock's price risk. I find that breaking down risk along those lines is a particularly helpful way of looking at stocks, so this journal entry takes a closer look at the concept. So what are operating risk and price risk? Operating risk is the risk to the company as a business. That includes anything that might adversely affect the company's market or its profitability (such as volatile raw-materials costs or rising labor costs). A high debt load compared with industry or market averages would also make for higher operating risk because it would magnify the bottom-line effects of a drop in demand. Basically, anything about the business that makes its earnings less certain or more unstable qualifies as operating risk.

Price risk, on the other hand, has more to do with the stock than the business. There are different ways to look for price risk, but the most common is probably looking at a stock's price multiples, such as P/E or price/book, against that of the industry, the market, or any other index that will yield a meaningful comparison. A stock whose multiples are comparatively high carries more price risk than one whose multiples are lower. When I look at a stock, I try and figure out how its operating risk balances its price risk. To think why that might be important, imagine a company in a turnaround situation--that is, one that carries a fair amount of operating risk. If the stock is expensive, I probably wouldn't be interested because much of the potential improvement in earnings is already figured into the price. And if those earnings don't materialize, the chances are good that the stock will tank. But if the stock is cheap, I might be inclined to take a chance on those theoretical, risky future earnings. The potential upside is great if the company comes through, and downside risk--or the price risk--is comparatively limited. I usually visualize the balance between operating and price risk as a four-box matrix, and I try and fit stocks into one of the four categories: low operating risk and high price risk, high operating risk and low price risk, low operating risk and low price risk, and high operating risk and high price risk.
Low operating risk and high price risk The leading stocks in today's market mostly fit into this box. These are the Coca-Colas, the Gillettes, the Microsofts--companies that have advantages such as leading market position, brand-name franchises, and superior profitability that enable them to post reliable earnings and growth, year in and year out, quarter after quarter. Smaller or less well-known companies with good managements or strong market niches can also end up here. These companies--though they occasionally post lower-thanexpected growth or weak earnings--have delivered over the long haul.

And the market has noticed. Clorox, for example, now commands 31 times its trailing earnings, a P/E that's 50% higher than its average P/E over the past five years. In other words, the market has raised the premium on its future earnings, in large part because the company has been so reliable in the past. If these companies don't meet or exceed those high expectations, these stocks could be in for a long period of sub-par returns until earnings catch up with the prices. And any glitch in earnings--and every company has glitches, no matter how steady it is over all--could send these stocks into a tailspin.
High operating risk and low price risk Cyclicals--with their reliably unreliable earnings-tend to crowd into this corner, though other companies, with less-than-ideal markets or mediocre managements, fit as well. In large part, these stocks can make up for their lack of earnings stability--a la the turnaround example above--or their choppy growth, with their low price risk. Low operating risk and low price risk These stocks are the Holy Grail of value investors. Warren Buffett's stocks fit into this category when he bought them, before they moved into the low operating risk, high price risk box. The big problem with this box is finding stocks that fit into it. As you've probably realized by now, most stocks tend to congregate in the two boxes above. Since the market is more or less efficient, it tends to exact a higher price for higher quality and a lower price for lower quality.

High operating risk and high price risk This playground is pretty much off limits to all but die-hard growth investors. Most often, hot start-ups and small tech plays end up here. These are companies whose businesses are new, or are so small that they carry a lot of operating risk. But they are also usually in popular or glamorous industries, which means that the market has put a high price tag on those uncertain earnings. In order for their high-priced stocks to do well, these companies need turn in some convincing evidence that they could be the next Microsoft.

What's important is really the exercise of considering which of the above categories is more appropriate to the stock and why. Because once you have a handle on that, you can compare the stock to your investment style and decide if it fits. A stock that's risky because its operations are unstable is a different kind of investment than one that's risky because it's expensive. An investor who might consider one might not consider the other. It's a case of investor know thyself and thy stock.

Questions:

1. This article draws a distinction between operating risk and price risk. Given the distinction in chapter 3 between diversifiable and non-diversfiable risk, what does operating risk measure? What does price risk measure? 2. The article then goes on to categorize firms based upon operating risk and price risk. Two categories include firms with high (low) operating risk and low (high) price risk. How would you explain the mismatch? Why might a firm with high (low) operating risk have low (high) price risk? 3. If you were an investor who is not diversified, which of the four groups would you invest in? Why or why not? 4. If you are an investor who is diversified, is this a useful categorization? If not, how would you modify it?
Morningstar

Market Risk & Time

While the stock and bond markets can be risky in the short run, time has a moderating effect on market risk. The longer you hold a stock or bond investment, the lower your chances of losing money, and the greater the odds of earning a return close to the long-term average. For example, a one-year investment in stocks has historically produced returns ranging from +53.9% to -43.3%. Over ten-year periods, however, returns have varied from -0.9% per year for the worst ten years to +20.1% per year for the best ten years.

Holding Period 1 Year 5 Years 10 Years

Range Of Returns on Stocks: 1926 to 1997 Best Return Worst Return +53.9 % -43.3 % +23.9 % -12.5 % +20.1 % - 0.9 %

15 Years 20 Years 25 Years

+18.2 % +16.9 % +14.7 %

+ 0.6 % + 3.1 % + 5.9 %

As you can see, risk can be substantial over short periods. But over longer horizons, the chance of losing money is substantially reduced. The same principle applies to bonds, though bonds are less risky than stocks. For long-term bonds, it takes ten years before returns are consistently positive; for shorter-maturity bonds, about three years. Of course, it should be noted that past performance in the stock and bond markets does not necessarily predict future performance.

Questions:

1. Do you think that stocks become less risky, relative to bonds, as your time horizon is lengthened? If so, why? If not, why not? 2. What are the implications of this article for the measures of risk and risk premiums used in the risk and return models developed in chapter 3?
The Wall Street Journal Interactive Edition -- January 23, 1998 Investors Must Recall Risk, Investing's Four-Letter Word By KAREN HUBE Staff Reporter of THE WALL STREET JOURNAL

What four letter word should pop into mind when the stock market takes a harrowing nose dive? No, not those. R-I-S-K. [Media] Risk is the potential for realizing low returns or even losing money, possibly preventing you from meeting important objectives, like sending your kids to the college of their choice or having the retirement lifestyle you crave. But many financial advisers and other experts say that these days investors aren't taking the idea of risk as seriously as they should, and they are overexposing themselves to stocks. "The market has been so good for years that investors no longer believe there's risk in investing," says Gary Schatsky, a financial adviser in New York. "And when the market drops hundreds of points and rebounds immediately, that belief is confirmed." The danger is that when the market declines and stays down for months -- as some analysts predict it eventually will -- investors won't be able to meet their short-term financial goals. Or, they will panic and sell their investments as their shares are declining in value, which is the worst possible time. So before the market goes down and stays down, be sure that you understand your tolerance for risk and that your portfolio is designed to match it. Assessing your risk tolerance, however, can be tricky. You must consider not only how much risk you can afford to take but also how much risk you can stand to take. What you can afford depends mainly on your time horizon -- how long before you will need the money. If your investments are targeted for your child's college tuition in three years, for instance, your

financial ability to take on risk is low because you may not have time to recover if the value of your portfolio declines. But if you have 10 years before your child heads to college, you can afford to take more risks because you would have plenty of time to ride out dips in the market. Determining how much risk you can stand -- your temperamental tolerance for risk -is more difficult. It isn't quantifiable. "A variety of behavioral factors come into play," says Richard Bernstein, director of quantitative research at Merrill Lynch & Co. in New York. "If my broker asks me if I want high-risk or low-risk securities, I may say high risk because I don't want to look wimpy." Similarly, some people will gloss over the less impressive details of their investing histories, says Ronald Roge, a financial adviser in Bohemia, N.Y. He routinely asks to see copies of his clients' tax returns to get a reliable account of gains or losses. "The aim is always to find the fine line between greed and fear," he says. To that end, many financial advisers, brokerage firms and mutual-fund companies have created risk quizzes to help people determine whether they are conservative, moderate or aggressive investors. Some firms that offer such quizzes include Merrill Lynch, T. Rowe Price Associates Inc., Baltimore, Zurich Group Inc.'s Scudder Kemper Investments Inc. of New York, and Vanguard Group in Malvern, Pa. "The typical investor may not have ever experienced a negative turn in the stock market. They need to be prepared for that," says Robert Benish, vice president of education programs for Scudder, whose questionnaire is part of a broader investing-education program. "We want to help them understand what risk means to them." Typically, risk questionnaires include seven to 10 questions about a person's investing experience, financial security and tendency to make risky or conservative choices. Some of these risk tests, such as one created by Vanguard (www.vanguard.com), can be found on-line. The benefit of the questionnaires is that they are an objective resource people can use to get at least a rough idea of their risk tolerance. "It's impossible for someone to assess their risk tolerance alone," says Mr. Bernstein. "I may say I don't like risk, yet will take more risk than the average person." Many experts warn, however, that the questionnaires should be used simply as a first step to assessing risk tolerance. "They are not precise," says Ron Meier, a certified public accountant who teaches investing-related courses at the College for Financial Planning in Denver, a unit of Apollo Group Inc., Phoenix. "They are good for leading discussions but not for coming up with a final risk score." The second step, many experts agree, is to ask yourself some difficult questions, such as: How much you can stand to lose over the long term? "Most people can stand to lose a heck of a lot temporarily," says Mr. Schatsky. The real acid test, he says, is how much of your portfolio's value you can stand to lose over months or years. Rather than using percentages, think in dollar terms. "When you convert percentages to figures, often you see very different psychological effects," says Richard Wagener, a financial adviser in Columbia, Md. The idea of a 20% decline on, say, a $150,000 portfolio is more abstract than a $30,000 loss, he says. Financial adviser Glen Clemans of Portland, Ore., says he cites the 1972-1974 bear market to help his clients realize how much they can lose. "I tell my clients to imagine they had put $100,000 in the S? 500 in November 1972," says Mr. Clemans. He then explains that after the first year, the investment would have been worth $88,000. "I watch to see how they flinch. Then I tell them that the next year, their investment would have been worth $67,000, and ask them 'So now what would you do?' " As it turns out, most people rank as middle-of-the-road risk-takers, say Mr. Clemans and other advisers. "Only about 10% to 15% of my clients are aggressive," says Mr. Roge. For some of the biggest risk-takers, particularly those who say they like to gamble, Mr. Roge recommends creating an "action account" that includes no more than 10% of their assets. Money in the account can be used to speculate in the stock market. "Some investors just love the excitement of getting a stock pick from a brother-in-

law, even though they may lose money," says Mr. Roge. "People who need that kind of action should have an outlet for it." Copyright 1998 Dow Jones & Company, Inc. All Rights Reserved.