FINM2401

CAPM AND COST OF CAPITAL

Last Week
2

Computing portfolio expected return and risk.

Covariance and correlation provide diversification benefits.
What we mean by an efficient portfolio.
What happens when we add a risk-free asset to a

portfolio.
Tangent portfolio (highest Sharpe Ratio)
Sharpe Ratio =

E R p rf
p

Lecture 10

This Week
3

Formalise CAPM
How to compute beta ()
Security Market Line (SML) v. Capital Market Line (CML)
Applications of CAPM
Equity cost of capital
Beta estimation
Putting it all together to find cost of capital

Lecture 10

Diversification with General Portfolios

4

Last Lecture, we saw that for a portfolio with arbitrary weights, the

standard deviation is calculated as:

Var (RP ) = Cov (RP ,RP ) = Cov

=

( x R ,R )
i

i x i Cov (Ri ,RP ) = i x i i p

,

Security i s contribution to the

volatility of the portfolio

SD (RP ) =
The contribution of
investment i to the
volatility of the portfolio
depends on the risk that
i has in common with
the portfolio.

6 4 4 4 44 7 4 4 4 4 48
x i SD (Ri ) Corr (Ri ,R p )

Amount
of i held

Total
Risk of i

Fraction of i s
risk that is
common to P

Incremental Risk:
Risk new security
adds to portfolio
Lecture 9

Efficient Portfolios
5

Efficient portfolios provide highest return for a given

level of risk or lowest risk for a given level of return.

If you can increase a portfolios Sharpe Ratio by adding

another security, then the original portfolio is NOT efficient.

What does adding a security do to the Sharpe Ratio

of a portfolio?

Sharpe Ratio if
Risk new security
adds to portfolio

Risk Premium of new security

E [Ri ] rf
i i , p

>

E R p rf
p

Lecture 10

Efficient Portfolios
6

Incremental Risk:
Risk new security
adds to portfolio

Risk Premium of new security

This incremental Sharpe ratio only makes

sense if correlation is positive.

Risk Premium: Suppose we give up the risk-free return and invest in

asset. : In order to gain this excess return we are taking on more risk?
Incremental Risk: How much additional risk are we taking by investing
in the asset?
If the incremental Sharpe Ratio is greater than the portfolio Sharpe
Ratio, then the portfolio isnt efficient because adding the new security
can increase return.
Lecture 9

Efficient Portfolios
7

Re-arranging:

E [Ri ] rf
i i , p

>

E R p rf

E [Ri ] rf >

i i , p

E [Ri ] > rf +

i i , p

p
p

(E R

rf

(E R

rf

If this inequality is true, then your original portfolio

was NOT the tangent portfolio

Lecture 10

Efficient Portfolio and Required Returns

8

Beta of Portfolio

i with respect to Portfolio P

i i ,P i ,P
=
= 2
P
P
P
i

i ,P

i ,P
=
i P

i will increase the

Sharpe ratio of portfolio P if its expected return E[Ri]
exceeds the required return ri , which is given by:

Increasing the amount invested in

P
i

ri = rf + (E [RP ] rf

)
Lecture 10

Try it out
Assume you own a portfolio of 25 different large
cap stocks. You expect your portfolio will have a
return of 12% and a standard deviation of 15%. A
colleague suggests you add gold to your portfolio.
Gold has an expected return of 8%, a standard
deviation of 25%, and a correlation with your
portfolio of -0.05. If the risk-free rate is 2%, will
adding gold improve your portfolios Sharpe ratio?

Lecture 10

Solution
P The beta of gold with your portfolio is:

G old G old ,P
25% 0.05

=
=
= 0.08333
P
15%
P The required return that makes gold an attractive
addition to your portfolio is:
rG old = rf + GP old (E [R P ] rf )
P
G old

= 2% 0.08333 (12% 2% ) = 1.67%

P Because the expected return of 8% exceeds the

required return of 1.67%, adding gold to your portfolio

will increase your Sharpe ratio.
Lecture 10

10

Expected Returns and the Efficient Portfolio

11

Expected Return of a Security

A portfolio is efficient if and only if the expected return of
every available security equals its required return.

eff
i

E [Ri ] = ri rf +

(E [Reff ] rf

Lecture 10

Finding the Efficient Combination

12

What is the efficient combination of the large cap

portfolio on slide 7 and gold? The risk-free rate is

2%.

Large Cap
Gold
Portfolio
E[R]
12%
8%
SD[R]
15%
25%
Correlation
-0.05
Lecture 10

Finding the Efficient Portfolio

13

As you add gold to your portfolio, the covariance of

gold to the resulting portfolio will change.

If P is a portfolio of L(Large Caps) and G(gold), then

G ,P = x G G2 + x L G ,L
Where

xG and xL are the weights of L and G in P

An excel spreadsheet can be used to compute the weights that

maximize the Sharpe Ratio of P
For these weights, adding more gold to your portfolio will not
give sufficient return to compensate for the additional risk.

The

required return on gold will be its expected return of 8%

Lecture 10

Finding the Efficient Portfolio

14
xgol d
0.00%
10.00%
15.00%
20.00%
24.00%
24.17%
25.00%

E[Rp ]
12.00%
12.60%
12.90%
13.20%
13.44%
13.45%
13.50%

Var[Rp ]
0.022500
0.022750
0.023344
0.024250
0.025200
0.025243
0.025469

SD[Rp ] Sharpe Ratio Cov(Rgol d ,Rp ) Corr(Rgol d ,Rp )

15.000%
0.666667
-0.001875
-0.050000
15.083%
0.702773
0.004375
0.116024
15.279%
0.713413
0.007500
0.196352
15.572%
0.719221
0.010625
0.272919
15.875%
0.720652
0.013125
0.330719
15.888%
0.720654
0.013228
0.333031
15.959%
0.720600
0.013750
0.344635

Beta
-0.083333
0.192308
0.321285
0.438144
0.520833
0.524022
0.539877

Reqd Return
on Gold
1.167%
4.038%
5.502%
6.907%
7.958%
8.000%
8.209%

The combination that maximises the Sharpe Ratio is

24.17% gold, 100% large caps, -24.17% risk-free asset.

A copy of this spreadsheet will be posted on Blackboard
You are not expected to solve for the weights, but should be

able to tell whether a given set of weights are optimal

Lecture 10

The Capital Asset Pricing Model

15

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.

Lecture 10

The CAPM Assumptions

16

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.
2. Investors hold only efficient portfolios of traded
securities - portfolios that yield the maximum
expected return for a given level of volatility.
3. Investors have homogeneous expectations
regarding the volatilities, correlations, and
expected returns of securities.
Lecture 10

Efficiency of the Market Portfolio

17

Given homogeneous expectations, all investors will

demand the same efficient portfolio of risky

securities.
The combined portfolio of risky securities of all
investors must equal the efficient portfolio.
Thus, if all investors demand the efficient portfolio,
and the supply of securities is the market portfolio,
the demand for market portfolio must equal the
supply of the market portfolio.

Lecture 10

Try it out..
P Suppose there are only three securities

available for investors:

P ABC total market cap of $3million
P DEF total market cap of $6million
P GHI total market cap of $1million

P If all the CAPM assumptions apply, what is the

weight of DEF in the risky portion of your

portfolio?
Lecture 10

18

Solution
P If all CAPM assumptions apply, you hold all

three securities in proportion to their market

cap.
P Therefore DEF is 6/10 = 60% of the risky assets
in your portfolio
P Note that you may also hold the risk free asset
(with either positive or negative weight)

Lecture 10

19

The Capital Market Line

20

35%

CML : E R p = rf + p
30%

(E [Rmkt ] rf )
mkt

25%
Capital Market Line

20%

Market Portfolio

15%
10%
5%

rf

0%
0%

5%

10%

15%

20%

25%

30%

35%
Lecture 10

The Capital Market Line

21

The expected return and volatility of a portfolio on

the capital market line are:

E [R xCML ] = (1 x ) rf + xE [RMkt ] = rf + x (E [RMkt ] rf

SD (R xCML ) = xSD (RMkt )

Lecture 10

Determining the Risk Premium

22

Market Risk and Beta

Given an efficient market portfolio, the expected return of an
investment is:

E [Ri ] = ri = rf + Mkt
(E [RMkt ] rf
i
1 4 44 2 4 4

The beta is defined as:

)
43

Risk premium for security i

Volatility of i that is common with the market

Mkt
i

i =

6 4 4 4 4 7 4 4 4 48
SD (Ri ) Corr (Ri ,RMkt )

SD (RMkt )

Cov (Ri ,RMkt )

=
Var (RMkt )
Lecture 10

Try it out
P Assume the risk-free return is 5% and the

market portfolio has an expected return of 12%

and a standard deviation of 44%.
P ATP Oil and Gas has a standard deviation of
68% and a correlation with the market of 0.91.
P What is ATPs beta with the market?
P Under the CAPM assumptions, what is its
expected return?
Lecture 10

23

Solution
i i ,mkt
0.68 0.91
i =
=
= 1.41
mkt
0.44

E [R i ] = rf + iMkt (E [R Mkt ] rf
= 5% + 1.41(12% 5%

)
) = 14.87%

Lecture 10

24

The Security Market Line

25

There is a linear relationship between a stocks beta

and its expected return (See figure on next slide).

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.

Lecture 10

Security Market Line

26

25%

25%
Market Portfolio

rf

20%

Expected Return

Expected Return

Market Portfolio

CML

15%
10%
5%

rf

0%
0%

10%
20%
Volatility

30%

20%
15%
10%
Security
Market
Line

5%
0%
0

0.5

1.5

Beta
Lecture 10

The Security Market Line

27

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 x i Ri ,RMkt )

P =
=
Var (RMkt )
Var (RMkt )
Cov (Ri ,RMkt )
= i x i
=
Var (RMkt )

i x i i
Lecture 10

Try it out
P Suppose the stock of the 3M Company (MMM)

has a beta of 0.69 and the beta of HewlettPackard Co. (HPQ) stock is 1.77.
P Assume the risk-free interest rate is 5% and the

expected return of the market portfolio is 12%.

P What is the expected return of a portfolio of

40% of 3M stock and 60% Hewlett-Packard

stock, according to the CAPM?
Lecture 10

28

Solution
P =

x
i

= (.40 )(0.69) + (.60 )(1.77) = 1.338

E [ R i ] = rf + iMkt ( E [ R Mkt ] rf )
E [ R i ] = 5% + 1.338(12% 5% ) = 14.37%

Lecture 10

29

CAPM Summary
30

The market portfolio is the efficient portfolio.

This means the market portfolio is the tangent portfolio and all
investors hold the market portfolio plus the risk free asset.
The risk premium for any security is proportional to

its beta with the market.

This means that beta is the relevant measure of risk and all
securities will lie on the Security Market Line.

Lecture 10

Cost of Capital
31

Cost of capital will depend on systematic risk.

Since a firm is financed by both debt and equity, its

cost of capital will be an average of its cost of debt

and its cost of equity.

Lecture 10

The Equity Cost of Capital

32

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

)
1 4 4 4 2 4 4 43
Risk Premium for security i

Lecture 10

Try it out
P Suppose you estimate that Wal-Marts 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.
P Which stock carries more total risk?
P Which has more market risk?

P If the risk-free interest rate is 4% and you estimate

the markets expected return to be 12%, calculate

the equity cost of capital for Wal-Mart and Johnson
& Johnson.
P Which company has a higher cost of equity capital?
Lecture 10

33

Solution
P Total risk is measured by volatility. Wal-Mart

stock has more total risk than J&J.

P Systematic risk is measured by beta. Johnson
& Johnson has a higher beta, so it has more
market risk than Wal-Mart.
P Johnson & Johnsons equity cost of capital is
rJ & J = 4% + 0.54 (12% 4%

) = 8.32%

P The equity cost of capital for Wal-Mart is

rW MT = 4% + 0.20 (12% 4%

) = 5.6%
Lecture 10

34

The Market Portfolio

35

The market portfolio is a value-weighted portfolio of

all securities in the market.

Weights are based on Market Capitalisation (share
price times number of shares outstanding).
Owning the market portfolio means owning the
same percentage of every company in the market.
This is a passive portfolio you dont need to rebalance it in response to price movements.

Lecture 10

Market Indexes
36

S&P 500
A value-weighted portfolio of the 500 largest U.S. stocks
Wilshire 5000
A value-weighted index of all U.S. stocks listed on the major
stock exchanges
Dow Jones Industrial Average (DJIA)
A price weighted portfolio of 30 large industrial stocks
S&P/ASX 200
A value-weighted portfolio of the 200 largest Australian stocks.
Approximately 78% of total Market Cap on the ASX
Lecture 10

The Market Risk Premium

37

Determining the Risk-Free Rate

The yield on Commonwealth Government Bonds
Match term of bond to term of investment you are valuing
The Historical Risk Premium
Estimate the risk premium (E[RMkt]-rf) using the historical
average excess return of the market over the risk-free interest
rate

Lecture 10

The Market Risk Premium

38

Using historical data has two drawbacks:

Standard errors of the estimates are large
Backward looking, so may not represent current expectations.
One alternative is to solve for the discount rate that

is consistent with the current level of the index.

rMkt =

Div 1
+ g = Dividend Yield + ExpectedDividendGrowthRate
P0

Lecture 10

Estimating Beta from Historical Returns

39

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 Commonwealth Bank and how it changes
with the market portfolio (using the S&P/ASX200
index as a proxy).

Lecture 10

Monthly Excess Returns: CBA and ASX200

40

0.2
0.15
0.1
0.05
0
Jan-12

Sep-11

May-11

Jan-11

Sep-10

May-10

Jan-10

Sep-09

May-09

Jan-09

Sep-08

May-08

Jan-08

-0.15

Sep-07

-0.1

May-07

-0.05

ASX200
CBA

-0.2
Lecture 10

Scatterplot of Monthly Excess Returns

41

CBA Return

0.2
0.15
0.1
0.05
0

-0.2

-0.15

-0.1

-0.05
0
-0.05

0.05

0.1

0.15

0.2

-0.1
-0.15
-0.2
Market Return
Lecture 10

Using Linear Regression

42

Linear Regression
The statistical technique that identifies the best-fitting line
through a set of points.

(R i

rf

) = i

+ i (RMkt rf ) + i

is the intercept term of the regression.

i(RMkt rf) represents the sensitivity of the stock to
market risk. When the markets return increases by 1%, the
securitys return increases by i%.
i is the error term and represents the deviation from the bestfitting line and is zero on average.
i

Lecture 10

Using Linear Regression

43

Alpha
Since E[i] = 0:

E Ri = rf + i (E RMkt rf ) +
1 4 4 44 2 4 4 4 43

Expected return for i from the SML

i
{

Distance above / below the SML

represents a risk-adjusted performance measure for the

historical returns.

If

i is positive, the stock has performed better than predicted

by the CAPM.

If

i is negative, the stocks historical return is below the SML.

Lecture 10

The Debt Cost of Capital

44

Debt Yields
Yield to maturity is the IRR an investor will earn from holding
the bond to maturity and receiving its promised payments.
If there is little risk the firm will default, yield to maturity is a
reasonable estimate of investors expected rate of return.
If there is significant risk of default, yield to maturity will
overstate investors expected return.

Lecture 10

The Debt Cost of Capital

45

If there is a chance of default, the expected return

on the debt will be:

rd = (1 p ) y + p ( y L ) = y pL
= Yield to Maturity Prob ( default ) Expected Loss Rate
The importance of the adjustment depends on the

riskiness of the bond.

Lecture 10

Debt Betas
46

Alternatively, we can estimate the debt cost of

capital using the CAPM.

Debt betas are difficult to estimate because
corporate bonds are traded infrequently.
One approximation is to use estimates of betas of
bond indices by rating category.

Lecture 10

Try it out
P DEF Corp. has outstanding 10 year bonds with a B

rating and a yield to maturity of 7.5%.

P The market risk premium currently stands at 4%,
and the risk free rate is 3%.
P Your research shows that the average beta for B
rated debt with 10-15 years to maturity is 0.40.
P You also find that the probability of default for B
rated debt given current economic conditions is 6%,
with an expected loss rate of 40%.
P Estimate the expected return on DEF Corp. bonds.
Lecture 10

47

Solution
P Expected Return:
P rd = y pL
P 7.5% 0.06 40% = 5.1%

P CAPM
P rd = rf + d (mkt risk premium)
P 3% + 0.4 4% = 4.6%

Lecture 10

48

A Projects Cost of Capital

49

All-equity comparables
Find an all-equity financed firm in a single line of business that
is comparable to the project.
Use the comparable firms equity beta and cost of capital as
estimates
Levered firms as comparables

Lecture 10

Asset (unlevered) cost of capital

50

Expected return required by investors to hold the

firms underlying assets.

Weighted average of the firms equity and debt costs
of capital

rU =

E +D

rE +

E +D

rD

Can also estimate rU using an asset beta:

U =

E
E +D

E +

D
E +D

D
Lecture 10

Cash and Net Debt

51

Some firms maintain high cash balances

Cash is a risk-free asset that reduces the average

risk of the firms assets

Since the risk of the firms enterprise value is what
were concerned with, leverage should be measured
in terms of net debt.

Net Debt = Debt Excess Cash and short-term investments

Lecture 10

Project Risk and Cost of Capital

52

Cost of capital should reflect the systematic risk of

the project

Firm asset betas or asset cost of capital will be an average of

the systematic risk of all projects in the firm. This may not
reflect the systematic risk in an individual project.

Lecture 10

Project Risk and Cost of Capital

53

Another factor that can affect market risk of a

project is its degree of operating leverage

Operating leverage is the relative proportion of
fixed versus variable costs
A higher proportion of fixed costs increases the
sensitivity of the projects cash flows to market risk
The projects beta will be higher
A higher cost of capital should be assigned

Lecture 10

Weighted Average Cost of Capital

54

Taxes A Big Imperfection

When interest payments on debt are tax deductible, the net
cost to the firm is given by:
Effective after-tax interest rate = r (1 C )
This is reflected in the after-tax weighted average cost of
capital (WACC):

rwacc =

E
E +D

rE +

D
E +D

rD (1 C )

Lecture 10

The Weighted Average Cost of Capital

55

How does rwacc compare with rU?

Unlevered cost of capital (or pretax WACC) is:
Expected

return investors will earn by holding the firms 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 firms assets.
With

taxes, WACC can be used to evaluate a project with the

same risk and the same financing as the firm.

Lecture 10

Final Thoughts on the CAPM

56

There are a large number of assumptions made in

the estimation of cost of capital using the CAPM.

How reliable are the results?

CAPM is practical, easy to implement, and robust.

CAPM requires managers to think about risk in the correct
way.

Lecture 10