Physical Assests versus Securities 137
to
r 2 6% (5%)2.0
16%.
As we shall see in Chapter 5, this change would have a dramatic effect on MicroDrive’s
stock.
Differentiate among the expected rate of return (r), the required rate of returnˆ
(r), and the realized, after-the-fact return (r-) on a stock. Which would have to be
larger to get you to buy the stock,ˆr or r? Wouldˆr, r, and r-typically be the same
or different for a given company?
What are the differences between the relative volatility graph (Figure 3-9), where
“betas are made,” and the SML graph (Figure 3-12), where “betas are used”?
Discuss both how the graphs are constructed and the information they convey.
What happens to the SML graph in Figure 3-12 when inflation increases or de-
creases?
What happens to the SML graph when risk aversion increases or decreases?
What would the SML look like if investors were indifferent to risk, that is, had
zero risk aversion?
How can a firm influence its market risk as reflected in its beta?
Physical Assets versus Securities
In a book on financial management for business firms, why do we spend so much time
discussing the risk of stocks? Why not begin by looking at the risk of such business
assets as plant and equipment? The reason is that, for a management whose primary ob-
jective is stock price maximization, the overriding consideration is the risk of the firm’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 Tire Company 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 nega-
tively correlated with Goodyear’s regular operations—when times are good and peo-
ple have plenty of money, they buy new tires, but when times are bad, they tend to
buy more recaps. Therefore, returns would be high on regular operations and low on
the recap division during good times, but the opposite would occur during recessions.
The result might be a pattern like that shown earlier in Figure 3-5 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 company as a whole.
This analysis can be extended to the corporation’s stockholders. Because
Goodyear’s stock is owned by diversified stockholders, the real issue each time manage-
ment makes an asset investment should be this: How will this investment affect the risk
of our stockholders? Again, the stand-alone risk of an individual project may be quite
high, but viewed in the context of the project’s effect on stockholders’ risk, it may not be
very large. We will address this issue again in Chapter 8, where we examine the effects
of capital budgeting on companies’ beta coefficients and thus on stockholders’ risks.
Explain the following statement: “The stand-alone risk of an individual project
may be quite high, but viewed in the context of a project’s effect on stockhold-
ers, the project’s true risk may not be very large.”
How would the correlation between returns on a project and returns on the
firm’s other assets affect the project’s risk?
Risk and Return 135
