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]

Where:
E(Ra)=expectedreturnforanasset
Rf = Risk-free interest rate
a,m= Beta of the asset with regard to the market
portfolio
E(Rm)=Expectedreturnforthemarketportfolio

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:
[RpRf]/p=[RmRf]/m
Performance of a portfolio that is not fully
diversified, such as a sector fund:
(RpRf)/p,m = RmRf

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

portfolio

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 rate
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
well:

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]
Where
Rf=U.S.dollardenominatedriskfreerate
G=dollardenominatedreturnsfortheproposed
investmentinrelationtodollardenominated
returnsontheglobalmarketindex
E(RG)=expecteddollardenominatedreturnon
theglobalmarketindex