Chapter 12: Risk, Return and Capital Budgeting

Question 1

What is a market portfolio?

Answer 1

A portfolio of all assets in the economy. In practice a broad stock market index is used to represent the market.

Question 2

What is Beta?

Answer 2

The sensitivity of a stock’s return to the return on the market portfolio.

Question 3

Fluctuations in common stock value have 2 elements; what are they?

Answer 3

Fluctuations in the first part reflect market risk; fluctuations in the second part reflect specific risk.

Question 4

What is the definition of Portfolio Beta?

Answer 4

The beta of a portfolio is just an average of the betas of the individual securities in the portfolio, weighted by the investment in each security.

Question 5

Formula for Portfolio Beta?

Answer 5

Portfolio beta = (fraction of portfolio in stock 1 X beta of stock 1) + (fraction of portfolio in stock 2 x beta of stock 2)

Question 6

What can Portfolio Beta predict?

Answer 6

The total risk (standard deviation) of a diversified portfolio.

Question 7

What is the Beta of a fully diversified portfolio, including all stocks?

Answer 7

A fully diversified portfolio must match the market, and therefore have a Beta of 1.0.

Question 8

What is market risk premium?

Answer 8

Risk premium of market portfolio. Difference between market return and return on risk-free Treasury bills.

Question 9

What is the market risk premium formula?

Answer 9

Market Risk Premium = Expected Market Return - Treasury Bill Return

Question 10

What is the risk premium formula?

Answer 10

Risk Premium = β(Market Risk Premium)

Question 11

What is the expected return formula?

Answer 11

Expected return = risk-free rate + expected risk premium
or
Expected return = risk-free rate + β(Market Risk Premium)

Question 12

What is the simple interpretation of CAPM?

Answer 12

The expected rates of return demanded by investors depend on two things: (1) compensation for the time value of money (the risk-free rate) and (2) a risk premium, which depends on beta and the market risk premium.

Question 13

What is the definition of CAPM?

Answer 13

Theory of the relationship between risk and return stating that the expected risk premium on any security equals its beta times the market risk premium.

Question 14

What is the project cost of capital?

Answer 14

Minimum acceptable expected rate of return on a project given its risk.

Question 15

What is the company cost of capital?

Answer 15

Opportunity cost of capital for investment in the firm as a whole. The company cost of capital is the appropriate discount rate for an average-risk investment project undertaken by the firm.

Question 16

How can you measure and interpret the market risk or beta of a security?

Answer 16

The sensitivity of a stock to market movements is known as beta. Those with a beta of less than 1.0 are not so sensitive to movements. Those with a beta of more than 1.0 are greater than 1.0 are particularly sensitive to market fluctuations. The average beta of all stocks is 1.0.

Question 17

What is the relationship between the market risk of a security and the rate of return that investors demand of that security?

Answer 17

The extra return that investors require for taking risk is known as the risk premium. This is distinct from the market risk premium, which is the risk premium on the market portfolio. The CAPM states that the expected risk premium of an investment should be proportional to both its beta and the market risk premium. The expected rate of return from any investment is equal to the risk-free interest rate plus the risk premium.

Question 18

What determines the opportunity cost of capital for a project?

Answer 18

The opportunity cost of capital is the return that investors give up by investing in the project rather than in securities of equivalent risk.