258 Part 3 Financial Assets
important step forward in " nance theory; they also have some de" ciencies when
applied in practice. As a result, the basic CAPM is still the most widely used
method for estimating required rates of return on stocks.SELF^ TEST Have there been any studies that question the validity of the CAPM?
Explain.8-6 SOME CONCLUDING THOUGHTS: IMPLICATIONS FOR
CORPORATE MANAGERS AND INVESTORSThe connection between risk and return is an important concept, and it has
numerous implications for both corporate managers and investors. As we will see
in later chapters, corporate managers spend a great deal of time assessing the risk
and returns on individual projects. Indeed, given their concerns about the risk of
individual projects, it might be fair to ask why we spend so much time discussing
the riskiness of stocks. Why not begin by looking at the riskiness of such business
assets as plant and equipment? The reason is that for management whose primary goal
is stock price maximization, the overriding consideration is the riskiness of the! rm’s
stock, and the relevant risk of any physical asset must be measured in terms of its effect on
the stock’s risk as seen by investors. For example, suppose Goodyear, the tire com-
pany, is considering a major investment in a new product, recapped tires. Sales of
recaps (hence, earnings on the new operation) are highly uncertain; so on a stand-
alone basis, the new venture appears to be quite risky. However, suppose returns
in the recap business are negatively correlated with Goodyear’s other operations—
when times are good and people have plenty of money, they buy new cars with
new tires; but when times are bad, they tend to keep their old cars and buy recaps
for them. Therefore, returns would be high on regular operations and low on the
recap division during good times, but the opposite would be true during reces-
sions. The result might be a pattern like that shown earlier in Figure 8-4 for Stocks
W and M. Thus, what appears to be a risky investment when viewed on a stand-
alone basis might not be very risky when viewed within the context of the com-
pany as a whole.
This analysis can be extended to the corporation’s stockholders. Because
Goodyear’s stock is owned by diversi" ed stockholders, the real issue each time
management makes an investment decision is this: How will this investment
affect the risk of our stockholders? Again, the stand-alone risk of an individual
project may look quite high; however, viewed in the context of the project’s effect
on stockholder risk, it may not be very large. We will address this issue again in
Chapter 12, where we examine the effects of capital budgeting on companies’ beta
coef" cients and thus on stockholders’ risks.
While these concepts are obviously important for individual investors, they
are also important for corporate managers. We summarize some key ideas that all
investors should consider:- There is a trade-off between risk and return. The average investor likes higher
returns but dislikes risk. It follows that higher-risk investments need to offer