chapter 11

# chapter 11 - Chapter 11 Risk return and capital budgeting...

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COPYRIGHT©ZHULI 1 Chapter 11 Risk, return, and capital budgeting

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COPYRIGHT©ZHULI 2 Objectives 1. Measure and interpret the market risk, or beta, of a security 2. Relate the market risk of a security to the rate of return that investors demand 3. Calculate the opportunity cost of capital for a period
COPYRIGHT©ZHULI 3 Content Measuring market risk Risk and return Capital budgeting and project risk

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COPYRIGHT©ZHULI 4 Market portfolio : portfolio of all assets in the economy. In practice a broad stock market index is used to represent the market Beta or β : sensitivity of a stock’s return to the return on market portfolio
COPYRIGHT©ZHULI 5 Measuring beta Aggressive stocks have high betas, betas greater than 1.0, meaning that their returns tend to respond more than one for one to changes in the return of the overall market. The betas of defensive stocks are less than 1.0. The returns of these stocks vary less than one for one with market returns. The average beta of all stocks is 1.0 exactly.

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COPYRIGHT©ZHULI 7 We can measure beta by the slope of a line fitted to the points in the figure β = 0.8

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COPYRIGHT©ZHULI 8 We can break down common stock returns into two parts: the part explained by market returns and the firm’s beta, and the part due to news that is specific to the firm. Fluctuations in the first part reflect market risk; fluctuations in the second part reflect unique risk
COPYRIGHT©ZHULI 9 The procedure for measuring companies’ betas 1. Observe rates of return, usually monthly, for the stock and the market 1. Plot the observations 1. Fit a line showing the average return to the stock at different market returns Bata is the slope of the fitted line.

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## This note was uploaded on 05/11/2010 for the course BUSINESS S 409 taught by Professor Terryryan during the Summer '10 term at Winthrop.

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chapter 11 - Chapter 11 Risk return and capital budgeting...

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