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(CAPM)
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1
2 2 2 2
σ B = .3(20 - 15) + .4(15 - 15) + .3(10 - 15)
=3.8%
15%
| | Standard
Deviation
4.0% Risk 65.8%
State Return
No deviation from 12%!
Sunny .5(33) + .5( - 9) = 12%
Normal .5(12) + .5(12) = 12% σ 50/50 = 0
Rainy .5( - 9) + .5(33) = 12%
Standard
Risk Deviation
2
ρ=-1
ρ= 1
1
Standard
Deviation
Risk
49% -
Unsystematic or diversifiable
risk (related to company-unique events)
24% -
19% -
Total Risk Systematic or nondiversifiable
risk (result of general market
influences)
Number of stocks
1 10 20 25 in portfolio
X Efficient frontier
X X
X X X
X X X X
RF --
wing
o
B orr
X Efficient frontier
RM --
g X X
e n din X X X
L
X X X X
RF --
SML
RF --
β
Systematic
Risk
SML
RM --
RF --
| | β
Systematic 1 2
Risk
= 8%
Incorrect
16% -- B acceptance
15% --
14% -- A WACC = 15%
Incorrect
rejection
R f = 7% --
If a firm uses its WACC to make accept/reject decisions for all types of projects, it will have a tendency toward incorrectly
accepting risky projects and incorrectly rejecting less risky projects.
20% --
High risk
(+6%)
WACC = 14% --
10% --
R f = 7% -- Moderate risk
Low risk (+0%)
(-4%)
Beta
With the subjective approach, the firm places projects into one of several risk classes. The discount rate used to value the project is
then determined by adding (for high risk) or subtracting (for low risk) an adjustment factor to or from the firm’s WACC.
Year kH kA kL kM
1 10% 10% 10% 10%
2 20% 10% 0% 10%
| | 0 | | |
-20 -10 10 20 30 Return on
-10 -- the
market,
-20 -- k i (%)