BBMF 2093 Corporate Finance

BBMF 2093 CORPORATE FINANCE
TUTORIAL 5 CAPITAL ASSET PRICING MODEL- C.A.P.M
1. Assuming that the CAPM approach is appropriate, compute the required rate of return for
each of the following stocks, given a risk-free rate of 0.07 and an expected return for the
market portfolio of 0.13:
Stock A B C D E
Beta 1.5 1.0 0.6 2.0 1.3
What implications can you draw?
For example, stock D having beta equal to 2.0 thus the required return of the stock D is 10 (which is
higher than the other stock.
Required return . (Rj) = Rf + [E(Rm) – Rf] Betaj
Req. (RA) = 0.07 + (0.13 – 0.07) (1.5) = 0.16 =16%

Req. (RB) = 0.07 + (0.13 – 0.07) (1.0) = 0.13 =13%
Req. (RC) = 0.07 + (0.13 – 0.07) (0.6) = 0.106 =10.6%
Req. (RD) = 0.07 + (0.13 – 0.07) (2.0) = 0.19 = 19%
Req. (RE) = 0.07 + (0.13 – 0.07) (1.3) = 0.148 =14.8%
The relationship between required return and beta should be stressed.
Stock with higher beta will have higher return eg stock d, beta=2, and required
return is 19%, stock b has beta =1. Return = 13%
2. On the basis of an analysis of past returns and of inflationary expectations, Marta Gomez
feels that the expected return on stocks in general is 12%. The risk-free rate on short-term
Treasury securities is now 7%. Gomez is particularly interested in the return prospects for
Kessler Electronics Corporation. Based on monthly data for the past five years, she has
fitted a characteristic line (SML) to the responsiveness of excess returns of the stock to
excess returns of the S&P500 Index and has found the slope of the line to be 1.67. If
financial markets are believed to be efficient, what return can she expect from investing
in Kessler Electronics Corporation?
Market risk premium = rm-rf

Required return . (Rj) = Rf + [E(Rm) – Rf] Betaj
3. Currently, the risk-free rate is 10% and the expected return on the market portfolio is
15%. Market analysts’ return expectations for four stocks are listed here, together with
each stock’s expected beta.
STOCK EXPECTED RETURN EXPECTED BETA
1. Stillman Zinc Corporation 17.0% 1.3
2. Union Paint Company 14.5% 0.8
3. National Automobile Company 15.5% 1.1
4. Parker Electronics, Inc. 18.0% 1.7
If the analysts’ expectations are correct, which stocks (if an) are overvalued? Which (if any)
are undervalued?
Stock Expected Required return, (sml)
return,ER
Stock 1 17.0% 0.1+ (0.15-0.10) x 1.3=16.3% UNDERVALUED

ER above SML line
Stock 2 14.5% 0.1+ (0.15-0.10) x 0.8 =14.0% UNDERVALUED

ER above SML line
Stock 3 15.5% 0.1 + (0.15-0.10) x 1.1 =15.5% NEUTRAL
Stock 4 18.0% 0.1 + (0.15-0.10) x 1.7 = 18.5% OVERVALUED

ER below SML line
Expected > required = under; expected < required = over

Undnervalued stocks: above the SML Line
Overvalued stocks: below the SML Line
Plot risk-free and market portfolio return to form SML line

Then only plot the stocks based on expected return
4. Salt Lake City Services, Inc., provides maintenance services for commercial buildings.
Currently, the beta on its common stock is 1.08. The risk-free rate is now 10%, and the
expected return on the market portfolio is 15%. It is January 1, and the company is
expected to pay a RM2 per share dividend at the end of the year, and the dividend is
expected to grow at a compound annual rate of 11% for many years to come. Based on
the CAPM and other assumptions you might make; what dollar value would you place on
one share of this common stock?
5. The finance director of Bentras plc wishes to find the company's optimal capital structure.
The cost of debt varies according to the company's credit rating, which itself depends,
amongst other factors, upon the level of gearing of the company.
The company's ungeared equity beta (asset beta) is 0.85. The risk free rate is 6% per
annum, and the market return 14% per annum. Corporate taxation is at the rate of 30% per
year.
Estimate the company's cost of equity using C.A.P.M (Assuming the company is
ungeared).
1. Mr. Rich owns a portfolio consisting shares of five public listed firms. The details of t
hese securities and his asset allocation are provided below:
The market return is 15% and risk-free investments offer 7%.
(a) Calculate the required rate of return for each security in Mr. Rich’s portfolio, using
the Capital Asset Pricing Model.
(b) Determine the portfolio beta. Is this portfolio riskier than the market? Justify.

BBMF 2093 Corporate Finance

Uploaded by

Copyright:

Available Formats

BBMF 2093 Corporate Finance

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

BBMF 2093 Corporate Finance

Uploaded by

Copyright:

Available Formats

BBMF 2093 CORPORATE FINANCE

TUTORIAL 5 CAPITAL ASSET PRICING MODEL- C.A.P.M

What implications can you draw?

Required return . (Rj) = Rf + [E(Rm) – Rf] Betaj

Req. (RA) = 0.07 + (0.13 – 0.07) (1.5) = 0.16 =16%

The relationship between required return and beta should be stressed.

Market risk premium = rm-rf

STOCK EXPECTED RETURN EXPECTED BETA

1. Stillman Zinc Corporation 17.0% 1.3

2. Union Paint Company 14.5% 0.8

3. National Automobile Company 15.5% 1.1

4. Parker Electronics, Inc. 18.0% 1.7

Stock 1 17.0% 0.1+ (0.15-0.10) x 1.3=16.3% UNDERVALUED

Stock 2 14.5% 0.1+ (0.15-0.10) x 0.8 =14.0% UNDERVALUED

Stock 3 15.5% 0.1 + (0.15-0.10) x 1.1 =15.5% NEUTRAL

Stock 4 18.0% 0.1 + (0.15-0.10) x 1.7 = 18.5% OVERVALUED

Expected > required = under; expected < required = over

Plot risk-free and market portfolio return to form SML line

You might also like