FNCE 203

Advanced Corporate Finance

Lecture 2 Risk & CAPM

Prof. Vito D. Gala

Upcoming Deadlines
Join a study group on Canvas by Jan 18th (Today!)
Max 4 people per group, and recommended min 3 people
Post on Canvas discussion board if you are still looking for
a team
After Jan 18th, unassigned students will be randomly
assigned to available study groups
Sign-up on Canvas for 1st case presentation starting
Jan 20th at 12:01am until Jan 23rd at 11:59pm to
ensure that youll get a presentation slot!
(soon after email me confirming slot & names of students in your group)
Todays Agenda

Quick review of last week

Review Cost of capital

We need to make sure everyone is on the same

page before moving onto newer topics like LBOs,
Mergers, etc.

Dont forget your nameplates!

Review DCF Valuation and NPV
Present value of future cash flows, CFt, where
CF > 0 represents a cash inflow
CF1 CF2 CF
NPV CF0 ...
(1 r1 ) (1 r2 )
1 2
(1 r )

Last class: we reviewed how to calculate the

cash flows, CF
Today: we will review how to calculate the
cost of capital, r
Review Calculating FCF
Free Cash Flow =
Operating cash flow (OCF)
- Net capital spending (NCS)
- Change in net working capital (NWC)
OCF captures incremental revenues & costs
NCS captures cash flows from capital spending
The last line corrects working capital items that
were counted as revenues or expenses, but are not
real cash flows (e.g. accounts receivable)
Review Capital Budgeting with FCF
1. Project incremental revenues and expenses
2. Create Pro Forma Income Statements
3. Calculate projects incremental FCF each year
a. Calculate Operating Cash Flow (OCF)
b. Estimate capital spending (NCS) [Dont forget salvage value!]
c. Find change in net working capital (NWC)
d. Combine (a)-(c) to get incremental FCF
4. Estimate their net present value by discounting!
Todays focus: Discount Rates

DCF and NPV employ discount rates

Risk-adjusted discount rates
Determine the expected return on equity (re ) and
debt (rd )
Next class we use the results to find firms overall
cost of capital, WACC
Historical Record of Returns & Risk

Lets compare $1 invested in 1925 in different

portfolios
Large company stocks
U.S. government bonds
U.S. Treasury bills
 Historical Record of Returns & Risk
$1 Investment in Different Portfolios
10000

1000
Nominal Dollars

100

10

1
1926

1936

1946

1956

1966

1976

1986

1996
0.1 Year
Large Company Stocks Long-Term Government Bonds Treasury Bills
Historical Record of Returns & Risk

Why is the historical return to stocks so much

higher than that of the Treasury bills?

To begin understanding why stocks had on

average a higher return, look at the year to year
returns for large company stocks versus that
of U.S. Treasury Bills
 Annual Returns Large Company Stocks
60.00%

40.00%
Total Return

20.00%

0.00%
26
31
36
41
46
51
56
61
66
71
76
81
86
91
96
01
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
20
-20.00%

-40.00%

-60.00% Year
 Annual Returns U.S. Treasury Bills
60.00%

40.00%

20.00%
Total Return

0.00%
26

31
36

41
46

51

56

61
66

71

76

81

86
91

96
19

19

19

19
19

19
19

19

19
19

19
19

19
19

19

-20.00%

-40.00%

-60.00%

Year
Basic Idea of Risk & Return
Greater spread in average returns implies
greater risk

Investors require higher returns to hold risky

assets
Investors want to be rewarded for bearing risk
Measuring Reward for Risk
Risk premium measures reward for risk
Risk premium = average excess return required
over and above the risk-free rate

Investors expected return to hold risky assets

Expected return = risk premium + risk-free rate
Measuring Expected Return

To measure the expected return of an asset, use

the mean of its possible returns!

Mean = Average value of all possible outcomes r

weighed by their probabilities Pr{r = x}

E( r ) Pr{r x }x
all x
Measuring Risk
To measure risk use the standard deviation
of its possible returns!
Variance = Average value of squared deviations
from the mean:

Var(r) Pr{r x} x E(r)

2

all x

Standard Deviation = Square root of variance

Historical Reward for Risk
Large company stocks, 1925-2003
Average annual return = 12.4%
Standard deviation = 20.4%
U.S. Treasury Bills, 1925-2003
Average annual return = 3.8%
Standard deviation = 3.1%
Average excess return for large company stocks
12.4% 3.8% = 8.6%
Calculating Required Return ( e.g. re )
Suppose XYZ stock has similar risk as the
historical portfolio of large company stocks,
and the current Treasury bills are paying 1.5%
What is a reasonable estimate for the required
return for this stock?

Answer = Historical risk premium of large

company stocks + current treasury bill return
i.e. 1.5% + 8.6% = 10.1%
Types of Risk
Systematic risk = risk that influences a large
number of assets
Also called market risk & undiversifiable risk
E.g. economic recession

Unsystematic risk = risk that affects certain

assets but cancels out overall
Also called diversifiable risk
Example: Blackberry loses market share
Eliminating Risk
How can investors eliminate risk?
Answer = Diversification!

Principle of diversification: spreading investment

across a number of assets will eliminate some, but
not all, of the risk

What risk will it eliminate?

Whats the intuition for this?

The Power of Diversification
If you randomly choose X # stocks from the
NYSE and form an equal weighted portfolio,
on average you would end up with a standard
deviation on your return of
X = 1, Standard deviation = 49.24%
X = 2, Standard deviation = 37.36%
X = 3, Standard deviation = 29.69%
X = 1000, Standard deviation = 19.21%
Graphically
Portfolio standard deviation

Why doesnt the risk totally disappear?

0
5 10 15
Number of Securities
Unique & Market Risk
Portfolio standard deviation

Diversifiable
risk

Market risk
0
5 10 15
Number of Securities
Determining Risk Premium
What causes one asset to have a larger risk
premium than another asset?

To answer, look at what we know about risk

Risk can be both systematic & unsystematic
Diversification eliminates unsystematic risk
Determining Risk Premium
Answer: if the asset is exposed to more systematic
risk!
Unsystematic risk can be diversified away at no cost
Hence, there is now reward for bearing it

Systematic Risk Principle = expected return

on a risky asset depends only its exposure to
systematic risk
Measuring Systematic Risk
Beta = Measures an assets exposure to systematic
risk (i.e. the risk of the market portfolio)

Say you are a diversified investor and hold the market portfolio.
Then the beta of an asset tells you how adding a bit more of the
asset would affect the overall risk of your portfolio

Market portfolio has beta = 1

If beta <1, asset will reduce portfolio variance
If beta >1, asset will increase portfolio variance
Measuring Beta Coefficient
Average risk is calculated using a market portfolio
Market Portfolio = portfolio of all assets in the
economy. In practice, a broad stock market index,
such as the S&P 500, is used to represent the market
Let E(rm) = expected return to market portfolio
Let m2 = variance of market portfolio

Then, beta is the sensitivity of a stocks return to

the return on the market portfolio
Measuring Beta Coefficient

im
i 2
m

What does it mean?

Measuring Beta Coefficient

im
i 2
m
Covariance of stock i
return with market return
im im i m

Variance of the market return

Calculating Beta for a Portfolio
Same approach for portfolio return

For N stocks portfolio, calculate the mean of

the assets betas using portfolio weights
N

i 1
i i

i = portfolio weight of stock i

i = beta of stock i
Interpreting Beta Coefficient

If an asset has a larger beta, do you think

its risk premium will be larger or smaller?

What will be the beta on a risk free assets

like U.S. Treasury bills?
Beta Practice Question
The stock for company X has
Beta = 0.2
Standard Deviation = 40%
The stock for company Y has
Beta = 1.7
Standard deviation = 25%
Which has greater total risk?
Which has greater systematic risk?
Which will have a higher risk premium?
Summary So Far
Only systematic risk should be rewarded

Beta is our measure of systematic risk

Expect a larger risk premium for greater beta

Risk-free rate has a zero beta

We will now put these together and show that the

risk premium is a linear function of beta. This is
called the CAPM (Capital Asset Pricing Model)
Capital Asset Pricing Model (CAPM)

E( ri ) r f E( rm ) r f i

The expected return of any portfolio i is just a

function of the risk free rate, the expected
market return, and the portfolios beta!
Expected return = risk free rate + risk premium
Risk premium = E( rm ) r f i
Interpreting CAPM

E( ri ) r f E( rm ) r f i

CAPM shows expected return depends on

Pure time value of money, rf
Reward for bearing risk, E(rm) - rf
Exposure to systematic risk, i
Market Risk Premium

E( ri ) r f E( rm ) r f i

Market Risk Premium = difference

between expected return on a market
portfolio and the risk-free rate
Implications of CAPM
We can calculate the expected return if we
know the beta, risk-free rate, and market
premium

See next slide for example

CAPM Practice Question
Suppose the risk-free rate is 5%, the market
risk premium is 8% and a particular stock has a
beta of 1.2
What is the risk premium of this stock?
What is the expected return (i.e. required return)
on this stock?
Answer CAPM

Risk Premium E( rm ) r f i
0.08 1.2 9.6%

Expected Return r f E( rm ) r f i
0.05 0.08 1.2
5% 9.6% 14.6%
Calculating rf and Market Premium
How do we calculate beta, the risk-free rate and
the expected market premium?
Risk-free rate is generally measured using the rate
for U.S. Treasuries
Expected market premium = average historical
return of the market (i.e. S&P 500) over risk-free rate

Basic idea: past market premium is good predictor of future.

But, this need not be true! In reality, the time period chosen
might matter.
Calculating Beta Method #1
Calculate historical covariance between stocks
individual return and market return, im , and
then divide by the historical market variance, m2
This is a direct application of definition i im m2

People generally use S&P 500 Index to proxy for market,

some use NYSE Index or Wilshire 5000 Index

Check sensitivity of beta estimate with respect to data

window: e.g., use previous five years of monthly returns vs.
previous ten years.
Calculating Beta Method #2
Linear regression: simply regress stocks
historical return on market return

To see why this works, rewrite CAPM:

E[ri ] rf i E rm rf
E[ri ] (1 i )rf i E rm

Coefficient from regressing stocks return, ri, on

market return, rm, will be the stocks beta!
Cautionary Notes!
These estimates of beta assume that it is
constant over time
Firms sensitivity to the market can change
As you will see in practice, the time period
chosen will often yield different betas

S&P 500 might not really capture the

market return
What about real estate? Foreign stocks? Bonds?
How Well Does CAPM Work?
Large debate as to whether the CAPM holds in
the real world
Here are few of the problems
Low-beta stocks earn more than predicted
Some type of stocks earn more than predicted
Small company stocks

Value (low ratio of market value to book value)

Momentum stocks (positive returns over last 6 months)

Low beta stocks earn too much
Multifactor Models
Some argue that factors like size, value, and
momentum capture types of systematic risk
not captured by market beta

They argue need for multifactor models

CAPM is a single-factor model
See next slide for example of multifactor model
Example Multifactor Model
The Fama-French-Carhart Model
E Ri rf E Rm rf
SMB E RSMB HML E RHML MOM E RMOM

First line is just CAPM [i.e. systematic risk]

SMB is risk captured by small firms
HML is risk captured by value stocks
MOM is risk captured by momentum
Concluding Remarks about CAPM
There is a lot of debate about whether
multifactor models are better than CAPM
Some say its just luck or data-mining and that
the CAPM is still the correct model
Others disagree and come up with theories as to
why these other factors should matter
Key Points for Today (I)
The cost of capital used to discount a projects,
divisions, or companys future cash flows
should reflect the riskiness of those cash flows

Investors are rewarded for bearing risk

Only applies to systematic risk!
Beta is our measure of systematic risk
Risk premium will be increasing in beta
Key Points for Today (II)

Capital Asset Pricing Model (CAPM) shows us

how we can compute the required return

E( ri ) r f E( rm ) r f i
In Next Class
Learn how to calculate cost of capital for
entire firm using CAPM and other tools

This is called the Weighted Average Cost

of Capital (WACC)

Readings: BMA 19.1-19.3