Finance

Created 7/1/1996
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Business Administration 130:

Using the CAPM

http://www.j-bradford-delong.net/Intro_Finance/BAonethirty9.html


Basics:

 


Using the CAPM:

So what does the CAPM--all of this adjusting of discount rates for "systematic" "market" risk--have to do with what we did in the first three or four weeks: this evaluating individual investment projects by calculating their NPVs?

One possibility: use the "company cost of capital" to assess and value individual investment projects.

A better thing to do: value each individual investment project as if it were a little mini-firm.

Companies should discount cash flows depending on their systematic riskiness--not on whether their expected return exceeds the company cost-of-capital.

Measuring betas:

Brealey and Myers wonder why they spend so much time on firm and industry betas given that what matters is the project beta. I find their excuses unconvincing... (musical "perfect pitch" metaphor)


Capital structure and company beta:

risk-free rate=5%; market required rate=10%

Unleveraged Firm

 Initial Price

 Market Goes Down

 Market Stays Constant

Market Goes Up

 Value of Firm

 $1,000

 $900

 $1,100

 $1,300

 Value of Bonds

 $0

 $0

 $0

 $0

 Value of Stocks (beta=1; 10 percent expected return)

 $1,000

 $900

 $1,100

 $1,300

 

 

Slightly Leveraged Firm

 Initial Price

 Market Goes Down

 Market Stays Constant

Market Goes Up

 Value of Firm

 $1,000

 $900

 $1,100

 $1,300

 Value of Bonds

 $500

 $525

 $525

 $525

 Value of Stocks (beta=2; 15% expected return)

 $500

 $375

 $575

 $775



Leveraged-to-the-Gills Firm

 Initial Price

 Market Goes Down

 Market Stays Constant

Market Goes Up

 Value of Firm

 $1,000

 $900

 $1,100

 $1,300

 Value of Bonds

 $850

 $892.50

 $892.50

 $892.50

 Value of Stocks (beta=6 2/3; 38.3% expected return)

 $150

 $7.50

 $207.50

 $407.50

 

 

 

Leveraged-Beyond-the-Gills Firm--Left as an Exercise for the Student

 Initial Price

 Market Goes Down

 Market Stays Constant

Market Goes Up

 Value of Firm

 $1,000

 $900

 $1,100

 $1,300

 Value of Bonds

 ??

 $900

 $1,100

 $1,100

 Value of Stocks (beta=6 2/3; 38.3% expected return)

 ??

 $0

 $0

 $200

Gearing; the effect of financial structure and leverage on security betas; firm beta as weighted average of debt beta and equity beta.


What If There Is No Beta Book Out There?


Examples:


Adam Smith
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