Chapter 12: Risk, return, capital budgeting Flashcards
How can you measure and interpret the market risk, or beta, of a security? (LO12-1)
The contribution of a security to the risk of a diversified portfolio depends on its market risk. But not all securities are equally affected by fluctuations in the market. The sensitivity of a stock to market movements is known as beta. Stocks with a beta greater than 1.0 are particularly sensitive to market fluctuations. Those with a beta of less than 1.0 are not so sensitive to such movements. The average beta of all stocks is 1.0.
What is the relationship between the market risk of a security and the rate of return that investors demand of that security? (LO12-2)
The extra return that investors require for taking risk is known as the risk premium. The market risk premium—that is, the risk premium on the market portfolio—averaged 7.7% between 1900 and 2017. The capital asset pricing model 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, so the CAPM boils down to
r = rf +β(rm −rf)
The security market line is the graphical representation of the CAPM equation. The security market line shows how the return that investors demand is related to the security’s beta.
What determines the opportunity cost of capital for a project? (LO12-3)
The opportunity cost of capital is the return that investors give up by investing in the proj- ect rather than in securities of equivalent risk. The CAPM implies that the opportunity cost of capital depends on the project’s beta. The company cost of capital is the expected rate of return demanded by investors in a company. It depends on the average risk of the com- pany’s assets and operations.
The opportunity cost of capital is determined by the use to which the capital is put. There- fore, required rates of return depend on the risk of the project, not on the risk of the firm’s existing business. The project cost of capital is the minimum acceptable expected rate of return on a project given its risk.
Your cash-flow forecasts should already factor in the chances of pleasant and unpleasant surprises. Potential bad outcomes should be reflected in the discount rate only to the extent that they affect beta.
