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    Chapter 14 - Risk From The Shareholders' Perspective

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    Kazi Hasan
    This document provides an overview of the Capital Asset Pricing Model (CAPM). It describes the key CAPM relationship that the expected return of an asset is equal to the risk-free rate plus the asset's beta multiplied by the expected return of the market portfolio over the risk-free rate. It outlines the key assumptions of CAPM and discusses how CAPM can be used for cost of capital calculations, evaluating portfolio performance, and estimating the required return for capital budgeting decisions. It also notes some limitations in CAPM's ability to explain all differences in returns among assets.

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    © All Rights Reserved
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    Chapter 14 - Risk From The Shareholders' Perspective

    Uploaded by

    Kazi Hasan
    11 views12 pages
    This document provides an overview of the Capital Asset Pricing Model (CAPM). It describes the key CAPM relationship that the expected return of an asset is equal to the risk-free rate plus the asset's beta multiplied by the expected return of the market portfolio over the risk-free rate. It outlines the key assumptions of CAPM and discusses how CAPM can be used for cost of capital calculations, evaluating portfolio performance, and estimating the required return for capital budgeting decisions. It also notes some limitations in CAPM's ability to explain all differences in returns among assets.

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    LECTURE1cap Budgeting

    Original Title

    Chapter 14

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    This document provides an overview of the Capital Asset Pricing Model (CAPM). It describes the key CAPM relationship that the expected return of an asset is equal to the risk-free rate plus the asset's beta multiplied by the expected return of the market portfolio over the risk-free rate. It outlines the key assumptions of CAPM and discusses how CAPM can be used for cost of capital calculations, evaluating portfolio performance, and estimating the required return for capital budgeting decisions. It also notes some limitations in CAPM's ability to explain all differences in returns among assets.

    Copyright:

    © All Rights Reserved
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    11 views12 pages

    Chapter 14 - Risk From The Shareholders' Perspective

    Uploaded by

    Kazi Hasan
    This document provides an overview of the Capital Asset Pricing Model (CAPM). It describes the key CAPM relationship that the expected return of an asset is equal to the risk-free rate plus the asset's beta multiplied by the expected return of the market portfolio over the risk-free rate. It outlines the key assumptions of CAPM and discusses how CAPM can be used for cost of capital calculations, evaluating portfolio performance, and estimating the required return for capital budgeting decisions. It also notes some limitations in CAPM's ability to explain all differences in returns among assets.

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    Chapter 14

    Risk from the Shareholders Perspective

    Focus of the chapter is the mean-variance capital


    asset pricing model (CAPM)
    Goal is to explain the relationship between risk and
    required return
    CAPM is a simple model of a complex reality

    The Key CAPM Relationship

    In an equilibrium market
    (Ra)=Rf+ a,m[E(Rm)Rf]

    Where:
    E(Ra)=expectedreturnforanasset
    Rf = Risk-free interest rate
    a,m= Beta of the asset with regard to the market
    portfolio
    E(Rm)=Expectedreturnforthemarketportfolio

    Key Assumptions Underlying CAPM

    Investors choose portfolios based on expected


    return and standard deviation
    Investors agree on expected returns, standard
    deviations, and correlation for all assets
    Investors can borrow and lend at risk-free rate
    Frictionless markets: no taxes or transaction
    costs, all investments completely divisible, no
    single investor large enough to affect price

    Uses of the CAPM Relationship

    Cost of capital calculations for a company


    Performance of a fully diversified stock or
    portfolio. Expected relationship:
    [RpRf]/p=[RmRf]/m
    Performance of a portfolio that is not fully
    diversified, such as a sector fund:
    (RpRf)/p,m = RmRf

    Usefulness of the CAPM

    CAPM is a simple model of a complex reality


    Standard for evaluation is not perfection in
    explaining observed returns,
    Standard for evaluation is sufficient combination
    of accuracy and simplicity for practical use

    Accuracy of the CAPM

    Hundreds of tests have been conducted


    Explains differences in return between assets, but does not
    explain all differences
    Factors other than beta appear to affect returns:
    Variance for the asset
    Stocks of small firms tend to provide higher returns
    Time-of-year effects
    Beta explains a relatively small portion of differences in
    returns among stocks
    Most differences appear to be company-specific rather
    than systematic

    Application to Capital Budgeting

    CAPM provides risk-adjusted required return on


    equity for the company
    CAPM can be applied if the risk-free rate, market
    risk premium, and systematic risk of the asset
    remain constant over time
    Typically assume a holding period equal to the
    average life of the proposed project.

    Application to Capital Budgeting

    Beta may be estimated using


    Historical

    returns for the company


    Betas for comparable companies
    Other methods such as state of nature models

    Application to Capital Budgeting

    Must estimate expected return on the market


    portfolio

    Long-term historical returns are commonly used


    Other methods such as analyst forecasts are also used
    There is still substantial debate as to the long-term
    expected return for the market portfolio
    Historical returns may over-estimate expected returns
    because a decrease in required return results in an
    increase in realized return

    Application to Capital Budgeting

    Risk-free rate
    Typically

    assume a long-term risk-free rate,


    matching the average life of the asset.

    Use in Capital Budgeting

    CAPM is widely used to estimate the required


    return on equity for capital budgeting
    Firms frequently look at other risk measures as
    well:

    Total project risk


    Impact of the project on company risk

    International Investments

    The international application to capital budgeting is


    often simplified to:
    Ke=Rf+ G[E(RG)Rf]
    Where
    Rf=U.S.dollardenominatedriskfreerate
    G=dollardenominatedreturnsfortheproposed
    investmentinrelationtodollardenominated
    returnsontheglobalmarketindex
    E(RG)=expecteddollardenominatedreturnon
    theglobalmarketindex

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