Chapter 5

Risk
Risk and
and
Return
Return

5.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 After studying Chapter 5,
you should be able to:
1. Understand the relationship (or “trade-off”) between risk and return.
2. Define risk and return and show how to measure them by calculating
expected return, standard deviation, and coefficient of variation.
3. Discuss the different types of investor attitudes toward risk.
4. Explain risk and return in a portfolio context, and distinguish between
individual security and portfolio risk.
5. Distinguish between avoidable (unsystematic) risk and unavoidable
(systematic) risk and explain how proper diversification can eliminate one
of these risks.
6. Define and explain the capital-asset pricing model (CAPM), beta, and the
characteristic line.
7. Calculate a required rate of return using the capital-asset pricing model
(CAPM).
8. Demonstrate how the Security Market Line (SML) can be used to describe
this relationship between expected rate of return and systematic risk.
9. Explain what is meant by an “efficient financial market” and describe the
three levels (or forms) of market efficiency.
5.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Risk
Risk and
and Return
Return
• Defining Risk and Return
• Using Probability Distributions to
Measure Risk
• Attitudes Toward Risk
• Risk and Return in a Portfolio Context
• Diversification
• The Capital Asset Pricing Model (CAPM)
• Efficient Financial Markets
5.3 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Defining Return
 Return is defined as “the total gain or
loss experienced on an investment
over a given period of time”.
 It is measured as follows:

5.4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Defining
Defining Return
Return
Income received on an investment plus
any change in market price,price usually
expressed as a percent of the beginning
market price of the investment. (see eqn 5.1
p.98)

D t + ( Pt – P t - 1 )
R=
Pt - 1
5.5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Defining Return
 Where:
 R = Actual, expected or required rate
of return during the period t
 Dt = Cash flow received from the
investment in the time period [t – 1 to
t]
 Pt = Price of the asset at time t
 Pt-1 = Price of the asset at time t – 1
5.6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Return
Return Example
Example
The stock price for Stock A was $10 per
share 1 year ago. The stock is currently
trading at $9.50 per share and shareholders
just received a $1 dividend.
dividend
What return was earned over the past year?

$1.00 + ($9.50 – $10.00 )

R= = 5%
$10.00
5.7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Another Example

5.8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Defining
Defining Risk
Risk
Risk is defined as “the chance of financial loss”.
It is the variability (difference) of returns from
those that are expected.

What rate of return do you expect on your

investment (savings) this year?
What rate will you actually earn?
Does it matter if it is a bank CD or a share
of stock?
5.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 The Risk-and-Return
Trade-off
 Investments must be analysed in terms
of both their return potential as well as
their riskiness or variability.

 Historically, its been proven that higher
returns are accompanied by higher
risks.


5.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Risk Assessment Of A Single
Asset – Probability Distribution
 Provides a more quantitative, yet
behavioural, insight into an asset’s risk.
 Probability is the chance of a particular
outcome occurring.
 Can be graphed as a model relating
probabilities and their associated
outcomes.
 The expected value of a return R [the most
likely return on an asset] can be
calculated by:

5.11 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Discrete versus. Continuous
Distributions

Discrete Continuous
0.4 0.035
0.35 0.03
0.3 0.025
0.25 0.02
0.2 0.015
0.15 0.01
0.1 0.005
0.05
0
0

4%
-5%

13%
22%
31%
40%
49%
58%
67%
-50%
-41%
-32%
-23%
-14%
–0.15 –0.03 9% 21% 33%

5.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Determining
Determining Expected
Expected
Return
Return (Discrete
(Discrete Dist.)
Dist.)
n
R = I= 1( Ri )( Pi )
R is the expected return for the asset,
Ri is the return for the ith possibility,
Pi is the probability of that return
occurring,
n is the total number of possibilities.
5.13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Risk Measurement – Standard
Deviation
 Measures the dispersion around the
expected value.
 The higher the standard deviation the
higher the risk.

5.14 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 How
How to
to Determine
Determine the
the Expected
Expected
Return
Return and
and Standard
Standard Deviation
Deviation

Stock BW
Ri Pi (Ri)(Pi)
The
-0.15 0.10 –0.015 expected
-0.03 0.20 –0.006 return, R,
0.09 0.40 0.036 for Stock
BW is .09
0.21 0.20 0.042
or 9%
0.33 0.10 0.033
Sum 1.00 0.090
5.15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Determining
Determining Standard
Standard
Deviation
Deviation (Risk
(Risk Measure)
Measure)
n
= 
i=1
( Ri – R ) 2
( P i )

Deviation , is a statistical
Standard Deviation,
measure of the variability of a distribution
around its mean.
It is the square root of variance.
Note, this is for a discrete distribution.
5.16 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 How
How to
to Determine
Determine the
the Expected
Expected
Return
Return and
and Standard
Standard Deviation
Deviation

Stock BW
Ri Pi (Ri)(Pi) (Ri - R )2(Pi)
–0.15 0.10 –0.015 0.00576
–0.03 0.20 –0.006 0.00288
0.09 0.40 0.036 0.00000
0.21 0.20 0.042 0.00288
0.33 0.10 0.033 0.00576
Sum 1.00 0.090 0.01728
5.17 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Determining
Determining Standard
Standard
Deviation
Deviation (Risk
(Risk Measure)
Measure)
n
= 
i=1
( Ri – R ) 2
( P i )

= .01728

 = 0.1315 or 13.15%

5.18 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Another example
 Shuia Na Ltd, a tennis-equipment manufacturer, is
attempting to choose the better of two alternative
investments, A and B. Each requires an initial outlay
of $10,000 and each has a most likely annual rate of
return of 15%. To evaluate the riskiness of these
assets, management has made pessimistic and
optimistic estimates of the returns associated with
each.
 The expected values for these assets are presented
in the Table on slide 18. Column 1 gives the Pri’s and
column 2 gives the ri’s, n equals 3 in each case. The
expected value for each asset’s return is 15%.
 Slide 19 shows the standard deviations for these
assets
5.19 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Another example – cont.

 Before looking at the standard deviations, can you identify which

asset is most risky?

5.20 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Another example – cont.

5.21 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Which Asset Is Riskier?

5.22 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Risk Measurement – Coefficient
Of Variation
 A measure of relative dispersion, useful in
comparing the risk of assets with differing
expected returns.

 The higher the coefficient of variation, the

greater the risk.

 Allows comparison of assets that have

different expected returns.

5.23 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Coefficient
Coefficient of
of Variation
Variation
The ratio of the standard deviation of
a distribution to the mean of that
distribution.
It is a measure of RELATIVE risk.
CV = /R
CV of BW = 0.1315 / 0.09 = 1.46
5.24 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Risk Preferences
 Three Preferences:
 Risk Averse: Require a higher rate of return to
compensate for taking higher risk.

 Risk Seeking: Will accept a lower return for a

greater risk.

 Risk Indifferent: Required return does not

change in response to a change in risk.

5.25 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Risk
Risk Attitudes
Attitudes
Certainty Equivalent (CE)
CE is the
amount of cash someone would
require with certainty at a point in
time to make the individual
indifferent between that certain
amount and an amount expected to
be received with risk at the same
point in time.
5.26 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Risk
Risk Attitudes
Attitudes
Certainty equivalent > Expected value
Risk Preference
Certainty equivalent = Expected value
Risk Indifference
Certainty equivalent < Expected value
Risk Aversion
Most individuals are Risk Averse.
Averse
5.27 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Risk
Risk Attitude
Attitude Example
Example
You have the choice between (1) a guaranteed
dollar reward or (2) a coin-flip gamble of
$100,000 (50% chance) or $0 (50% chance).
The expected value of the gamble is $50,000.
• Mary requires a guaranteed $25,000, or more, to
call off the gamble.
• Raleigh is just as happy to take $50,000 or take
the risky gamble.
• Shannon requires at least $52,000 to call off the
gamble.
5.28 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Risk
Risk Attitude
Attitude Example
Example
What are the Risk Attitude tendencies of each?

Mary shows “risk aversion” because her

“certainty equivalent” < the expected value of
the gamble.
Raleigh exhibits “risk indifference” because her
“certainty equivalent” equals the expected value
of the gamble.
Shannon reveals a “risk preference” because
her “certainty equivalent” > the expected value
of the gamble.
5.29 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Portfolios
 A portfolio is a collection of assets.

 An efficient portfolio is:

 One that maximises the return for a given level
of risk.
 OR

 One that minimises risk for a given level of

return.

5.30 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Portfolio Return
 Is calculated as a weighted average of returns on the
individual assets from which it is formed.
 Is calculated by (Eqn 5.6):



 Where:
 rp = Return on a portfolio
 wj = Proportion of the portfolio’s total dollar value
 represented by asset j
 rj = Return on asset j

5.31 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Determining
Determining Portfolio
Portfolio
Expected
Expected Return
Return
m
RP =  ( Wj )( Rj )
J=1

RP is the expected return for the portfolio,

Wj is the weight (investment proportion)
for the jth asset in the portfolio,
Rj is the expected return of the jth asset,
m is the total number of assets in the
5.32
portfolio.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Determining
Determining Portfolio
Portfolio
Standard
Standard Deviation
Deviation
m m
P = 
J=1
Wj Wk jk
K=1
Wj is the weight (investment proportion)
for the jth asset in the portfolio,
Wk is the weight (investment proportion)
for the kth asset in the portfolio,
jk is the covariance between returns for
5.33
the jth and kth assets in the portfolio.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 What is Covariance?
 Covariance is a statistical measure of the degree to which two
variables (eg, securities‘ returns) move together.
 Positive covariance shows that the two variables move together.
 Negative covariance suggests that the two variables move in
opposite diiections.
 Zero covariance means that the two variables show no tendency
to vary together in either a positive or negative linear fashion.
 Covariance between security returns complicates the calculation
of portfolio standard deviation.
 Covariance between securities provides for the possibility of
eliminating some risk without reducing potential return.

5.34 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Covariance

jk = j k rjk

j is the standard deviation of the jth asset
in the portfolio,
k is the standard deviation of the kth asset
in the portfolio,
rjk is the correlation coefficient between the
jth and kth assets in the portfolio.

5.35 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Correlation
 A statistical measure of the relationship, if any,
between a series of numbers representing data of
any kind.

 Three types:
 Positive Correlation: Two series move in the
same direction.
 Uncorrelated: No relationship between the two
series.
 Negative Correlation: Two series move in
opposite directions.

5.36 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Correlation
Correlation Coefficient
Coefficient
A standardized statistical measure
of the linear relationship between
two variables.

Its range is from –1.0 (perfect

negative correlation), through 0
(no correlation), to +1.0 (perfect
positive correlation).
5.37 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Correlation
 The degree of correlation is measured
by the correlation coefficient.

5.38 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Diversification
 Combining assets with low or negative
correlation can reduce the overall risk of the
portfolio.
 Combining uncorrelated risks can reduce overall
portfolio risk.
 Combining two perfectly positively correlated
assets cannot reduce the risk below the risk of
the least risky asset.
 Combining two assets with less than perfectly
positive correlations can reduce the total risk to a
level below that of either asset.

5.39 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Diversification

5.40 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Correlation, Diversification,
Risk & Return
 The lower the correlation between
asset returns, the greater the potential
diversification of risk.

5.41 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Portfolio
Portfolio Risk
Risk and
and
Expected
Expected Return
Return Example
Example
You are creating a portfolio of Stock D and Stock
BW (from earlier). You are investing $2,000 in
Stock BW and $3,000 in Stock D. D Remember that
the expected return and standard deviation of
Stock BW is 9% and 13.15% respectively. The
expected return and standard deviation of Stock D
is 8% and 10.65% respectively. The correlation
coefficient between BW and D is 0.75.
0.75
What is the expected return and standard
deviation of the portfolio?
5.42 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Determining
Determining Portfolio
Portfolio
Expected
Expected Return
Return
WBW = $2,000/$5,000 = 0.4
WD = $3,000/$5,000 = 0.6

RP = (WBW)(RBW) + (WD)(RD)
RP = (0.4)(9%) + (0.6)(
0.6 8%)
8%

RP = (3.6%) + (4.8%)
4.8% = 8.4%
5.43 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Determining
Determining Portfolio
Portfolio
Standard
Standard Deviation
Deviation

P = 0.0028 + (2)(0.0025) + 0.0041

P = SQRT(0.0119)
P = 0.1091 or 10.91%

You will not be asked to do this

calculation.
5.44 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Determining
Determining Portfolio
Portfolio
Standard
Standard Deviation
Deviation
The WRONG way to calculate is a
weighted average like:
P = 0.4 (13.15%) + 0.6(10.65%)
P = 5.26 + 6.39 = 11.65%

10.91% = 11.65%
5.45 This is INCORRECT.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Summary
Summary ofof the
the Portfolio
Portfolio
Return
Return and
and Risk
Risk Calculation
Calculation
Stock C Stock D Portfolio
Return 9.00% 8.00% 8.64%
Stand.
Dev. 13.15% 10.65% 10.91%
CV 1.46 1.33 1.26

The portfolio has the LOWEST coefficient

of variation due to diversification.
5.46 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Diversification
Diversification and
and the
the
Correlation
Correlation Coefficient
Coefficient
Combination
SECURITY E SECURITY F E and F
INVESTMENT RETURN

TIME TIME TIME

Combining securities that are not perfectly,

positively correlated reduces risk.
5.47 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Total
Total Risk
Risk == Systematic
Systematic
Risk
Risk ++ Unsystematic
Unsystematic Risk
Risk
Total Risk = Systematic Risk +
Unsystematic Risk
Systematic Risk is the variability of return
on stocks or portfolios associated with
changes in return on the market as a whole.
It cannot be avoided
Unsystematic Risk is the variability of return
on stocks or portfolios not explained by
general market movements. It is avoidable
through diversification.

5.48 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Systematic Risk and
Unsystematic Risk
 Other names for these terms are:
 Systematic risk
 Unavoidable risk
 Nondiversifiable risk
 Unsystematic risk
 Avoidable risk
 Diversifiable risk

5.49 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Total
Total Risk
Risk == Systematic
Systematic
STD DEV OF PORTFOLIO RETURN Risk
Risk ++ Unsystematic
Unsystematic Risk
Risk
Factors such as changes in the nation’s
economy, tax reform by the Congress,
or a change in the world situation.

Unsystematic (diversifiable) risk

Total
Risk
Systematic (nondiversifiable) risk

NUMBER OF SECURITIES IN THE PORTFOLIO

5.50 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Total
Total Risk
Risk == Systematic
Systematic
Risk
Risk ++ Unsystematic
Unsystematic Risk
Risk
Factors unique to a particular company
STD DEV OF PORTFOLIO RETURN

or industry. For example, the death of a

key executive or loss of a governmental
defense contract.

Unsystematic risk
Total
Risk
Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

5.51 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Capital
Capital Asset
Asset
Pricing
Pricing Model
Model (CAPM)
(CAPM)
CAPM is a model that describes the
relationship between risk and
expected (required) return.
In this model, a security’s expected
(required) return is the risk-free rate
plus a premium based on the
systematic risk of the security.
5.52 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 CAPM
CAPM Assumptions
Assumptions
1. Capital markets are efficient.
2. Homogeneous investor expectations
over a given period.
3. Risk-free asset return is certain
(use short- to intermediate-term
Treasuries as a proxy).
4. Market portfolio contains only
systematic risk (use S&P 500 Index
or similar as a proxy).
5.53 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Characteristic
Characteristic Line
Line
EXCESS RETURN Narrower spread
ON STOCK is higher correlation

Rise
Beta = Run

EXCESS RETURN
ON MARKET PORTFOLIO

Characteristic Line
5.54 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Calculating “Beta”
on Your Calculator
Time Pd. Market My Stock
The Market
1 9.6% 12%
and My
2 –15.4% –5% Stock
3 26.7% 19% returns are
4 –0.2% 3% “excess
5 20.9% 13% returns” and
6 28.3% 14% have the
7 –5.9% –9% riskless rate
8 3.3% –1% already
9 12.2% 12%
subtracted.
10 10.5% 10%
5.55 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Calculating “Beta”
on Your Calculator
• Assume that the previous continuous
distribution problem represents the “excess
returns” of the market portfolio (it may still be
in your calculator data worksheet – 2nd Data ).
• Enter the excess market returns as “X”
observations of: 9.6%, –15.4%, 26.7%, –0.2%,
20.9%, 28.3%, –5.9%, 3.3%, 12.2%, and 10.5%.
• Enter the excess stock returns as “Y” observations
of: 12%, –5%, 19%, 3%, 13%, 14%, –9%, –1%,
12%, and 10%.
5.56 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Calculating “Beta”
on Your Calculator
• Let us examine again the statistical
results (Press 2nd and then Stat )
• The market expected return and standard
deviation is 9% and 13.32%. Your stock
expected return and standard deviation is
6.8% and 8.76%.
• The regression equation is Y= a + bX. Thus,
our characteristic line is Y = 1.4448 + 0.595 X
and indicates that our stock has a beta of
0.595.
5.57 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 What
What is
is Beta?
Beta?
An index of systematic risk.
risk
It is the measure of market (non-diversifiable)
risk, and measures the sensitivity of a stock’s
returns to changes in returns on the market
portfolio.
The beta for the market portfolio is 1.0
The beta for a portfolio is simply a weighted
average of the individual stock betas in the
portfolio.
5.58 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Capital Asset Pricing Model
(CAPM) – Portfolio Betas
 Are interpreted exactly the same way as individual
asset betas.
 Can calculated by:

 Where:
 wj = The proportion of the portfolio’s dollar
value represented by asset j
 βj = The beta of asset j

5.59 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Characteristic
Characteristic Lines
Lines
and
and Different
Different Betas
Betas
EXCESS RETURN Beta > 1
ON STOCK (aggressive)
Beta = 1
Each characteristic
line has a Beta < 1
different slope. (defensive)

EXCESS RETURN
ON MARKET PORTFOLIO

5.60 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Security
Security Market
Market Line
Line

Rj = Rf + j(RM – Rf)
Rj is the required rate of return for stock j,
Rf is the risk-free rate of return,
j is the beta of stock j (measures
systematic risk of stock j),
RM is the expected return for the market
portfolio.
5.61 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Security
Security Market
Market Line
Line
Rj = Rf + j(RM – Rf)
Required Return

RM Risk
Premium
Rf
Risk-free
Return
M = 1.0
Systematic Risk (Beta)
5.62 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Capital Asset Pricing Model
(CAPM) – Beta Coefficient

5.63 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Security
Security Market
Market Line
Line
• Obtaining Betas
• Can use historical data if past best represents the
expectations of the future
• Can also utilize services like Value Line, Ibbotson
Associates, etc.
• Adjusted Beta
• Betas have a tendency to revert to the mean of 1.0
• Can utilize combination of recent beta and mean
• 2.22 (0.7) + 1.00 (0.3) = 1.554 + 0.300 = 1.854 estimate
5.64 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Determination
Determination of
of the
the
Required
Required Rate
Rate of
of Return
Return
Lisa Miller at Basket Wonders is attempting
to determine the rate of return required by
their stock investors. Lisa is using a 6% Rf
and a long-term market expected rate of
return of 10%.
10% A stock analyst following the
firm has calculated that the firm beta is 1.2.
1.2
What is the required rate of return on the
stock of Basket Wonders?
5.65 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 BWs
BWs Required
Required
Rate
Rate of
of Return
Return
RBW = Rf + j(RM – Rf)
RBW = 6% + 1.2(
1.2 10% – 6%)
6%
RBW = 10.8%
The required rate of return exceeds
the market rate of return as BW’s
5.66 beta exceeds the market beta (1.0).
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Determination
Determination ofof the
the
Intrinsic
Intrinsic Value
Value of
of BW
BW
Lisa Miller at BW is also attempting to
determine the intrinsic value of the stock.
She is using the constant growth model.
Lisa estimates that the dividend next period
will be $0.50 and that BW will grow at a
constant rate of 5.8%.
5.8% The stock is currently
selling for $15.

What is the intrinsic value of the stock?

Is the stock over or underpriced?
underpriced
5.67 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
  Remember, from Chapter 4, the
value of a share of stock is
calculated by:
 V = D1/(ke – g)
 So the intrinsic value of BW is:

5.68 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Determination
Determination ofof the
the
Intrinsic
Intrinsic Value
Value of
of BW
BW
Intrinsic $0.50
=
Value 10.8% – 5.8%

= $10

The stock is OVERVALUED as

the market price ($15) exceeds
the intrinsic value ($10).
$10
5.69 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Security
Security Market
Market Line
Line
Stock X (Underpriced)
Required Return

Direction of
Movement Direction of
Movement

Rf Stock Y (Overpriced)

Systematic Risk (Beta)

5.70 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Determination
Determination of
of the
the
Required
Required Rate
Rate of
of Return
Return
Small-firm Effect
Price/Earnings Effect
January Effect

These anomalies have presented

serious challenges to the CAPM
theory.
5.71 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.