Aims of the chapter In this chapter the concepts of market risk and beta will be described and this

will include how each can be measured. The capital asset pricing model (CAPM for short) will be introduced and, through the use of beta, applied to the concept of risk and the measurement of market and investment risk. The relationship of market risk and the risk of a share to the rate of return that investors require will be explained. This required return, or opportunity cost of capital, will be described and calculated and its application in capital budgeting and project risk derivation shown. Measuring market risk By holding a portfolio of investments comprising shares in different businesses, in different industries, it is possible to diversify away quite a lot of the risk. However, part of the risk of share ownership cannot be diversified away. This is because this part of the risk relates to factors which affect all businesses and their returns. This part of risk is known as market risk or systematic risk; it is caused by macroeconomic factors like changes in interest rates, changes in oil prices, etc. Total risk of investing in a particular share involves: Unsystematic risk (or project specific risk) which is diversifiable by holding a large portfolio of shares. Systematic risk (or market risk) which is risk borne by all companies. Risk premium is the difference between market return and the return from the risk free asset. The part of total risk which cannot be diversified away requires a risk premium to compensate investors for bearing it. This risk premium relates to the extent to which the particular share is affected by the macroeconomic factors associated with systematic risk. Beta is a measure of movements of a shares return to the return on the market portfolio. As risk depends upon exposure to macroeconomic events, it can be measured as the sensitivity of a shares return to fluctuations in

Chapter 4: Capital budgeting risk and return

returns on the market portfolio as a total market portfolio consisting of all types of investments is difficult to establish, a substitute such as the FT All Share Index is used as a proxy for the market portfolio. This sensitivity is termed as the shares beta (). Measuring beta As you will have already worked out, some shares will be less affected than others by market fluctuations. Investment managers generally refer to these as follows: where shares are not very sensitive to market fluctuations and therefore have a beta less than one defensive shares And where shares are sensitive to market changes and therefore have a beta value greater than one aggressive shares. Obviously investors will want to hold a portfolio of aggressive shares should they expect the market to rise in the near future and hold a portfolio of defensive shares should they anticipate the market will fall in the near future. Procedure for measuring real companies betas (in the UK): 1. Follow the rates of return for a particular UK company, usually monthly/weekly returns over a particular time period and also track the returns for a proxy of the market index such as the FT All Share Index over the same period. 2. Plot the observations (i.e. the company share returns on the y axis and the proxy for the market returns over the same period on the x-axis). 3. Fit a line of best fit showing the average returns for the share at different market returns. 4. Beta of the share will be the slope of the fitted line (usually calculated in practice using a technique known as regression analysis).

Activity 4.1 At this point you may find it useful to go through how BMM calculate the betas for Turbot-Charged Seafood, Amazon.com and Exxon Mobil. Portfolio betas The diversification of shares decreases the variability from unique risk but not from market risk. The beta of a portfolio of shares is ust an average of the betas of the individual shares in the portfolio, eighted by the investment in each share. 59 Financial management Worked example 4 Calculate the portfolio beta if you have invested 25% in ICI shares, 25% in British irways shares and 50% in British Petroleum shares; and their respective betas re 1.2, 1.0 and 0.8 olution to Worked example 4 he portfolio beta is calculated as follows: (0.25 1.2) + (0.25 1.0) + (0.5 0.8) 0.3 + 0.25 + 0.4 = 0.95 Risk and return The market risk premium can be defined as the difference etween the market return and the return on risk-free treasury bills; sually a proxy is adopted for the market return such as the FTSE 100 all share index (in the UK) or the S & P 500 index (in the US) nd the return on the risk free asset is the interest payable on reasury bills issued by the government. For example, if the return n he risk-free asset is 4.0% and the return on the market portfolio is 3.0% then the risk premium is 13.0 4.0 = 9.0%.You must remember that the risk-free treasury bills will have a zero beta and the fully diversified market portfolio will have a beta of ne; therefore, if you are told that the return on treasury bills is 4%and the return on the market portfolio is 13%, you should be able toplot the expected return against the beta; as illustrated below. The bold line represents the security market line which shows the relationship between expected return and beta.

Figure 4.1 Plot of expected return against beta Chapter 4: Capital budgeting risk and return University of London External System 41 From this figure, you will notice that given the expected return for risk-free treasury bills (zero beta asset) and the expected return for the market portfolio (unitary beta asset), you will be able to calculate the expected return for any asset which has a beta between zero and one. For example, if you have a portfolio split evenly between risk-free assets (which offer an interest rate of 4%) and the market portfolio (which offers an expected return of 13%) the expected return for the portfolio will be: (0.5 13%) + (0.5 4%) = 8.5% You can also calculate the expected return for this example more formally by using the following formulae: (i) Market risk premium = (rm rf) = 13% 4% = 9% (ii) Risk premium of an investment = (rm rf) You multiply (i) by beta as beta measures risk relative to the market on any asset.

(iii) Risk premium of an investment with beta of 0.5 and marketrisk premium of 9% = (rm rf) = 0.5 9% = 4.5% (iv) Total expected return (r) = risk-free rate + risk premium of investment = rf + (rm rf) = 8.5% Capital asset pricing model ri = rf + (rm rf) where: ri is the required rate of return on a particular investment i rf is the risk-free rate is a measure of the extent to which investment i is affected by macroeconomic factors rm is the expected average return from investing in the market portfolio of shares. This formula is commonly used to calculate expected returns and states the basic risk-return relationship called the Capital Asset Pricing Model or CAPM. According to the CAPM, expected rates of return for all securities and all portfolios lie on the security market line as illustrated above. 59 Financial management 42 University of London External System The basic idea behind the CAPM is that investors expect a reward for waiting and taking on risk. The riskier the investment, the greater the expected return. Therefore, if you invest in a risk-free asset, you just receive the rate of interest, say 4%, whereas if you invest in risky shares, you can expect to gain an extra return or risk premium, say 9% for the increased risk you take on by investing in shares. So if you invest in something twice as risky as the market (i.e. = 2) then the risk premium is doubled. CAPM is the theory of the relationship between risk and return which states that the expected risk premium on any share equals the shares beta multiplied by the market risk premium. Remember, the CAPM is only a model of risk and return. However, the CAPM does capture two simple but fundamental ideas useful to investment managers. First, almost everyone agrees that investors require some extra return for taking on risk. Secondly, investors are principally concerned with the market risk (the risk which they cannot diversify away). To calculate the returns that investors are expecting from particular shares, you require the risk-free rate, the expected market risk premium, and beta. For example, if the interest on treasury bills is 4% and the market risk premium is 10% and the beta for Company Z shares is 0.65 then the expected return on Company Z shares will be: Expected return = risk-free rate + (beta market risk premium) = 4% + (0.65 10%) = 10.5%

Activity 4.2 Calculate the expected return for a share if the risk-free rate of return is 8% and the market premium is 12% and the beta for the company share is 0.87. Then discuss how the beta for a company may be calculated in practice. See VLE for solution Project returns and the opportunity cost of capital The opportunity cost of capital is the return that investors give up by investing in the project rather than in securities of equivalent risk. Worked example 5 Company Y has forecasted the cash flows on a project and estimate that the internally required rate of return on this project (internal rate of return) is 10%. Risk-free treasury bills offer a return of 4% and the expected risk premium is 7%. Calculate whether the project is feasible if (a) the project is a sure thing (i.e. the beta is zero) Chapter 4: Capital budgeting risk and return University of London External System 43 (b) the beta for company Y is 0.4 (c) the beta for company Y is 0.9. Solution to Worked example 5 To answer this question you need to calculate the opportunity cost of capital. Since we have already established in an earlier chapter that NPV is the best criterion for project selection we need to note in this question that the selected hurdle rate (cost of capital) is the relevant rate for a particular risk level. Thus if a company presently had assets with risk class of 0.40 the required return the hurdle rate in the calculation below is 6.8%, but if faced with a new riskier area of business with of 0.90 then the hurdle rate is 10.30%. If the company has a zero beta then r = 4% + (0 7%) = 4% If the company has a beta of 0.4 then r = 4% + (0.4 7%) = 6.8% If the company has a beta of 0.9 then r = 4% + (0.9 7%) = 10.3% Company Y would only consider the project if the beta was either zero or 0.4. If the beta is 0.9 then company Y should not take on the project as the project is riskier than the internal rate of return required by the firm (i.e. 0.3% is more than 10%). (i) The corporate cost of capital is based on a portfolio of assets with individual betas c = i (ii) When we are analysing whether a project is feasible the selection of an individual project beta (or individual area of business beta) will be preferred to the companys cost of capital as the latter will be a weighted average of all project betas for the company (the average of the betas for all business areas). In practice, the security market line is a good indicator for project acceptance. If the return on the project lies above the security market line, then the return is higher than investors can expect to get by investing in the capital market.