Introduction to Corporate Finance

PART 2: VALUATION, RISK AND RETURN

Note: The figures show scatter plots of monthly returns on OrotonGroup shares (Figure 7.2a), AGL Energy shares (Figure 7.2b) and an equally

weighted portfolio of those two shares (Figure 7.2c) versus the monthly return on the ASX 200 share index. The returns were calculated from

share price and index data sourced from http://au.finance.yahoo.com.

FIGURE 7.C SCATTER PLOT OF MONTHLY RETURNS FOR A PORTFOLIO INVESTED EQUALLY IN OROTONGROUP

AND AGL ENERGY AGAINST THE ASX 200 INDEX

−15%

−10%

−5%

0%

5%

10%

15%

−15% −10% −5% 0% 5% 10% 15%

Portfolio Monthly return (%)

ASX 200 Index Monthly return (%)

Slope = beta = 0.9

Source: Elroy Dimson, Paul Marsh and Mike Staunton, ‘Triumph of the Optimists,’ Credit Suisse Global Investment Returns Yearbook 2010.

Published by ABN AMRO, London. Updates provided by Dimson, et al. to 2009. Authors’ estimates for 2010. Reprinted with permission.

Risk and Expected Returns

The risk-based approach to calculating expected returns involves two steps. The first step is to develop a

measure of a particular asset’s systematic risk. In beta we have such a measure. The second step involves

translating the asset’s beta into an estimate of expected return. To see how that process works, examine

Figure 7.3.^8

In Figure 7.3, we plot the beta against the expected return for two important assets. First, suppose

an asset is available that pays a given return with certainty; in this case, 4%. We designate this as the

risk-free asset. Its return is not subject to systematic risk (therefore its beta equals zero) or default risk.

In reality, no asset can promise a completely risk-free return, but a US Treasury bill comes very close.

In 2011, at least one rating agency downgraded the US government’s credit rating due to persistent

budget deficits. Australian treasury instruments have been awarded the highest credit ratings by Fitch,

Standard & Poor’s and Moody’s since 2011, 2003 and 2002 respectively. (Details are contained in the

article: http://www.abc.net.au/news/2011-11-29/fitch-rating-australia/3701752.) Thus, we can think of

an Australian Treasury note as a proxy for a risk-free asset. In Figure 7.3, the risk-free rate is 4%.

8 Notice that Figure 7.3 is conceptually different from Figures 7.2a and 7.2b. The earlier figures compared actual returns on particular

shares to actual returns on a market index. In Figure 7.3 we are establishing a connection between risk, as measured by beta, and

expected returns.

How would you estimate the

share beta for a particular

company?

thinking cap
question