Chapter 12 - CHAPTER 12 Risk, Return and Capital Budgeting...

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CHAPTER 12 Risk, Return and Capital Budgeting
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Topics Covered Risk and Return CAPM Measuring Market Risk Beta Capital Budgeting and Project Risk
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Capital Asset Pricing Model (CAPM) Model linking risk and required returns. CAPM suggests that there is a Security Market Line (SML) that states that a stock’s required return equals the risk-free return plus a risk premium that reflects the stock’s risk after diversification. r i = r RF + (r M – r RF ) b i Primary conclusion: The relevant riskiness of a stock is its contribution to the riskiness of a well- diversified portfolio.
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Beta Measures a stock’s market risk, and shows a stock’s volatility relative to the market. Indicates how risky a stock is if the stock is held in a well-diversified portfolio. Measures Sensitivity of a stock’s return to the return on the market portfolio.
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Comments on beta If beta = 1.0, the security is just as risky as the average stock. If beta > 1.0, the security is riskier than average. If beta < 1.0, the security is less risky than average. Most stocks have betas in the range of 0.5 to 1.5.
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Can the beta of a security be negative? Yes, if the correlation between Stock i and the market is negative (i.e., ρ i,m < 0). If the correlation is negative, the regression line would slope downward, and the beta would be negative. However, a negative beta is highly unlikely.
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Calculating betas Well-diversified investors are primarily concerned with how a stock is expected to move relative to the market in the future. Without a crystal ball to predict the future,
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Chapter 12 - CHAPTER 12 Risk, Return and Capital Budgeting...

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