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Capital Asset Pricing Model
Capital Asset Pricing Model
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i (RM
RF)
1
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? ?
=3.8
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4.0%
Risk
65.8%
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Expected return for Sun Tan Company = 12% Expected return for Umbrella Company = 12% Standard deviation for Sun Tan Company = 17.15% Standard deviation for Umbrella Company = 17.15%
Find the expected return and standard deviation for a portfolio which invests half its money in the Sun Tan and half its money in Umbrella Company.
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E?R 50/50 A! .5(12%) .5(12%) ! 12% W 50/50 { .5(17.15%) .5(17.15%) Why not?
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Return .5(33) + .5( - 9) = 12% .5(12) + .5(12) = 12% .5( - 9) + .5(33) = 12%
W 50/50 ! 0
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4.
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Portfolio Choice
U 2 U1 U 0
Expected Return
Risk
Standard Deviation
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=-1 =1
1
Risk
Standard Deviation
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19% Total Risk Systematic or nondiversifiable risk (result of general market influences) 10
Capital Asset Pricing Model
1
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25
X Efficient frontier X X X X X X X X X
RF --
Risk
Std dev
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RM -X X X RF -Risk
X Efficient frontier X X X X X X
Std dev
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SML
RF --
Systematic Risk
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SML RM --
RF -| 1 | 2
Systematic Risk
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CAPM
Provides a convenient measure of systematic risk of the volatility of an asset relative to the markets volatility. is this measure--gauges the tendency of a securitys return to move in tandem with the overall markets return. Average systematic risk High systematic risk, more volatile than the market Low systematic risk, less volatile than the market
F !1 F "1 F 1
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Tucson Electric Power California Power & Lighting Litton Industries Tootsie Roll Quaker Oats Standard & Poors 500 Stock Index Procter & Gamble General Motors Southwest Airlines Merrill Lynch Roberts Pharmaceutical
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2006 Betas:
B A
Incorrect rejection
R f ! 7% --
F B ! 1.2
Beta
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.
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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 firms WACC.
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Finding Beta for Three Companies: High, Average, and Low Risk & Market
Year 1 2 3
RH
10% 20% 25%
R
10% 10% 20%
RL
10% 0% 15%
R
10% 10% 20%
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Rm ( )
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