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RISK, RETURN, AND CAPITAL BUDGETING

Earlier we began to come to grips with the topic of risk. We made the distinction between unique risk and macro, or market, risk. Unique risk arises from events that affect only the individual firm or its immediate competitors; it can be eliminated by diversification. But regardless of how much you diversify, you cannot avoid the macroeconomic events that create market risk.

This is why investors do not require a higher rate of return to compensate for unique risk but do need a higher return to persuade them to take on market risk. How can you measure the market risk of a security or a project? We will see that market risk is usually measured by the sensitivity of the investment`s returns to fluctuations in the market. We will also see that the risk premium investors demand should be proportional to this sensitivity. This relationship between risk and return is a useful way to estimate the return that investors expect from investing in common stocks.

Finally, we will distinguish between the risk of the company`s securities and the risk of an individual project. We will also consider what managers should do when the risk of the project is different from that of the company`s existing business.

After studying this material you should be able to

_ Measure and interpret the market risk, or beta, of a security.

_ Relate the market risk of a security to the rate of return that investors demand.

_ Calculate the opportunity cost of capital for a project.

Measuring Market Risk

Changes in interest rates, government spending, monetary policy, oil prices, foreign exchange rates, and other macroeconomic events affect almost all companies and the returns on almost all stocks. We can therefore assess the impact of ¬macro ­ news by tracking the rate of return on a market portfolio of all securities. If the market is up on a particular day, then the net impact of macroeconomic changes must be positive. We

know the performance of the market reflects only macro events, because firm-specific events ¤that is, unique risks ¤average out when we look at the combined performance of thousands of companies and securities.

In principle the market portfolio should contain all assets in the world economy ¤ not just stocks, but bonds, foreign securities, real estate, and so on. In practice, however, financial analysts make do with indexes of the stock market, usually the Standard & Poor`s Composite Index (the S&P 500).1

Our task here is to define and measure the risk of individual common stocks. You can probably see where we are headed. Risk depends on exposure to macroeconomic events and can be measured as the sensitivity of a stock`s returns to fluctuations in returns on the market portfolio. This sensitivity is called the stock`s beta. Beta is often written as the Greek letter.

MEASURING BETA

Earlier we looked at the variability of individual securities. Compaq had the highest standard deviation and Exxon the lowest. If you had held Compaq on its own, your returns would have varied almost three times as much as if you had held Exxon. But wise investors don`t put all their eggs in just one basket: they reduce their risk by diversification. An investor with a diversified portfolio will be interested in the effect each stock has on the risk of the entire portfolio.

Diversification can eliminate the risk that is unique to individual stocks, but not the risk that the market as a whole may decline, carrying your stocks with it.

Some stocks are less affected than others by market fluctuations. Investment managers talk about ¬defensive ­ and ¬aggressive ­ stocks. Defensive stocks are not very sensitive to market fluctuations. In contrast, aggressive stocks amplify any market movements. If the market goes up, it is good to be in aggressive stocks; if it goes down, it is better to be in defensive stocks (and better still to have your money in the bank).

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 ¤no surprises here ¤1.0 exactly.

Now we`ll show you how betas are measured

MARKET PORTFOLIO Portfolio of all assets in the economy. In practice a broad stock market index, such as the Standard & Poor`s Composite, is used to represent the market.

BETA Sensitivity of a stock`s return to the return on the market portfolio.