Lecture Notes Week 8-2

Corporate Finance
Systematic Risk
❑ Systematic risk
➢ Risk attributable to market wide risk sources, which will
remain even after extensive diversification.
➢ Uncertainty caused by conditions in the general economy
like inflation, interest rates, exchange rates, Corporate
cycle.
➢ These factors will affect all assets in the portfolio.
➢ Also called: Market risk, or Non-diversifiable risk
❑ Unsystematic risk
➢ Risk of events occurring that are firm specific, or industry
specific, and do not affect all assets.
➢ Unsystematic risk can be eliminated by diversification.
➢ For example: Strike in a company, Change in CEO
➢ Also called: Firm specific, or Diversifiable risk
❑ When investors combine many firms in a portfolio, they can
easily eliminate all unsystematic risk through diversification.
❑ Some stocks in the portfolio will perform worse than
expected, but others will do better than expected – the
average becomes predictable (just like the coin tosses!).
❑ The volatility (sd) in the portfolio will decline until only the
systematic risk, which affects all firms, remains.
❑ Therefore, the return that investors require for holding the
shares of your company (the required rate of return, or cost
of equity) does not depend on the total amount of risk in
your stock (sd), but only on the amount of systematic risk.
❑ Investors don’t care about unsystematic risk, because they
will eliminate this anyway!
Measuring systematic risk
❑ Every security will be affected by systematic risk, but not
every security equally – some will be affected more than
others.
❑ To measure the amount of systematic risk in a security, we
need to know how sensitive the security is to fluctuations in
the overall market.
❑ Our measure of systematic risk, beta (β), considers the
correlation between a share’s historical returns and the
market’s historical returns.
❑ β tells us the percentage change in the share price that we
can expect for each 1% change in the overall market.
❑ If the price of a security tends to fluctuate a lot together with
the market, then the systematic risk in that security is high.
❑ We measure the performance of the overall market by looking

at the returns of a market portfolio – an index that represents
the entire market, such as the ASX200 or S&P500.
❑ The beta (β) of the overall market portfolio is 1.0 (If the market
increases by 1%, we expect the market portfolio to increase by
1%, duh.)
❑ Security returns that move one for one with the market on
average have a beta of 1. Security returns that move more
than the market have a beta greater than 1, and ones that
move less than the market, a beta of less than 1.
➢ As the financial manager of UniCo, you are investigating the
cost of equity of the firm. Suppose that, in the coming year,
you expect the company’s share to have a standard deviation
of 41% and a beta of 0.6. The shares of your main competitor
SysCo’s, is expected to have a standard deviation of 30% and
a beta of 1.2.
➢ Which share carries more total risk and which has more
systematic risk?
➢ As the financial manager of UniCo, you are investigating the
cost of equity of the firm. Suppose that, in the coming year,
you expect the company’s share to have a standard deviation
of 41% and a beta of 0.6. The shares of your main competitor
SysCo’s, is expected to have a standard deviation of 30% and
a beta of 1.2.
➢ Which share carries more total risk and which has more
systematic risk?
➢ Assuming that the investors in your company’s shares are
well diversified, which stock will they prefer? For which stock
will they require a higher return?
Corporate Finance
Computing Beta
Computing Beta
❑ As said, our measure of systematic risk, beta (β),

considers the correlation between a share’s historical
returns and the market’s historical returns.
❑ β tells us the percentage change in the share price
that we can expect for each 1% change in the overall
market.
❑ How can we compute beta?
Corporate Finance
Capital Asset Pricing Model

❑ Financial managers need to calculate the required rate of return by

investors for holding the company’s shares (the cost of equity).
❑ The Capital Asset Pricing Model (CAPM) describes the relation
between the expected (required) return on a stock, and its systematic
risk. (Only systematic risk determines the share’s expected returns:
remember, investors don’t care about firm-specific risk, because it is
diversifiable)
❑ The idea of the CAPM is that the expected return on any security
comes from:
➢ a risk-free rate of return to compensate for inflation and the time
value of money, even with no risk of losing money
➢ a risk premium that varies with the systematic risk.
❑ Expected Return = Risk-free rate + Risk Premium for

Systematic Risk.
❑ Capital Asset Pricing Model (CAPM):
𝐸 𝑅 = 𝑟𝑓 + 𝛽(𝐸(𝑅)𝑀𝑘𝑡 − 𝑟𝑓 )
▪ 𝐸 𝑅 : Expected return
▪ 𝑟𝑓 : risk-free rate
▪ 𝐸 𝑅 𝑀𝑘𝑡 : Expected return on the market portfolio
▪ (𝐸(𝑅)𝑀𝑘𝑡 − 𝑟𝑓 ): Market risk premium
➢ The capital budgeting team of Woolworths is calculating
the cost of equity capital of the company. Suppose that
the systematic risk associated with Woolworths is
measured by a beta of 0.67. The current risk-free return is
0.8%, and the current expected return by investors on the
market portfolio is 6.4%. What is the cost of equity capital
for Woolworths?
❑ CAPM: 𝐸 𝑅 = 𝑟𝑓 + 𝛽(𝐸(𝑅)𝑀𝑘𝑡 − 𝑟𝑓 )
= 0.008 + 0.67 × 0.064 − 0.008 = 0.0455 𝑜𝑟 4.55%
➢ Suppose the risk-free return is 3% and you measure the
market risk premium to be 7%. Qantas has a beta of 1.72.
According to the CAPM, what is its expected return for
investors holding the Qantas stock?
❑ CAPM: 𝐸 𝑅 = 𝑟𝑓 + 𝛽(𝐸(𝑅)𝑀𝑘𝑡 − 𝑟𝑓 )
= 0.03 + 1.72 × 0.07 = 0.1504 𝑜𝑟 15.04%
❑ The Security Market Line is a graphical representation of the CAPM.
The expected return of any security, is a simple linear function of the
amount of systematic risk in that security (beta).

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Corporate Finance

❑ We measure the performance of the overall market by looking

❑ As said, our measure of systematic risk, beta (β),

Capital Asset Pricing Model

❑ Financial managers need to calculate the required rate of return by

❑ Expected Return = Risk-free rate + Risk Premium for

❑ Capital Asset Pricing Model (CAPM):

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