CAPM and required return Answer: e Diff: M

i. Historical rates of return for the market and for Stock A are given below:

Year Market Stock A

1 6.0% 8.0%

2 -8.0 3.0

3 -8.0 -2.0

4 18.0 12.0

If the required return on the market is 11 percent and the risk-free rate is 6 percent, what is

the required return on Stock A, according to CAPM/SML theory?

a. 6.00%

b. 6.57%

c. 7.25%

d. 7.79%

e. 8.27%
CAPM and required return Answer: a Diff: M

ii. Some returns data for the market and for Countercyclical Corp. are given below:

Year Market Countercyclical

1999 -2.0% 8.0%

2000 12.0 3.0

2001 -8.0 18.0

2002 21.0 -7.0

The required return on the market is 14 percent and the risk-free rate is 8 percent. What is

the required return on Countercyclical Corp. according to CAPM/SML theory?

a. 3.42%

b. 4.58%

c. 8.00%

d. 11.76%

e. 14.00%

Portfolio return Answer: c Diff: M

iii. Stock X, Stock Y, and the market have had the following returns over the past four years.
 Year Market X Y

1999 11% 10% 12%

2000 7 4 -3

2001 17 12 21

2002 -3 -2 -5

The risk-free rate is 7 percent. The market risk premium is 5 percent. What is the required

rate of return for a portfolio that consists of $14,000 invested in Stock X and $6,000 invested

in Stock Y?

a. 9.94%

b. 10.68%

c. 11.58%

d. 12.41%

e. 13.67%
Portfolio return Answer: b Diff: M

iv. The risk-free rate, kRF, is 6 percent and the market risk premium,

(kM – kRF), is 5 percent. Assume that required returns are based on the CAPM. Your $1 million

portfolio consists of $700,000 invested in a stock that has a beta of 1.2 and $300,000 invested in a

stock that has a beta of 0.8. Which of the following statements is most correct?

a. The portfolio’s required return is less than 11 percent.

b. If the risk-free rate remains unchanged but the market risk premium increases by 2 percentage

points, the required return on your portfolio will increase by more than 2 percentage points.

c. If the market risk premium remains unchanged but expected inflation increases by 2 percentage

points, the required return on your portfolio will increase by more than 2 percentage points.

d. If the stock market is efficient, your portfolio’s expected return should equal the expected return on

the market, which is 11 percent.

e. None of the statements above is correct.

Portfolio return Answer: c Diff: M

v. A portfolio manager is holding the following investments:

Stock Amount Invested Beta

X $10 million 1.4

Y 20 million 1.0

Z 40 million 0.8
 The manager plans to sell his holdings of Stock Y. The money from the sale will be used to

purchase another $15 million of Stock X and another $5 million of Stock Z. The risk-free rate is

5 percent and the market risk premium is 5.5 percent. How many percentage points higher will

the required return on the portfolio be after he completes this transaction?

a. 0.07%

b. 0.18%

c. 0.39%

d. 0.67%

e. 1.34%
i. CAPM and required return Answer: e Diff: M

kA = 6% + (11% - 6%)bA.
Calculate bA as follows using a financial calculator:
6 Input 8 +
-8 Input 3 +
-8 Input -2 +
18 Input 12 +

0  y ,m
 swap bA = 0.4534.
kA = 6% + 5%(0.4534) = 8.2669%  8.27%

y bX bY k^ p ( $$ 1070 ) ( $$ 2070 ) ( $$ 4070 ) ( $$ 2570 ) ( $$700 ) ( $$ 4570 )

ii y . CAPM and required return Answer: a Diff: M

With your financial calculator input the following:

-2 Input 8 +
12 Input 3 +
-8 Input 18 +
21 Input -7 +

0  y ,m
 swap bC = -0.76.
kC = 8% + (14% - 8%)(-0.76) = 8% - 4.58% = 3.42%.

bX bY k^ p ( $$ 1070 ) ( $$ 2070 ) ( $$ 4070 ) ( $$ 2570 ) ( $$700 ) ( $$ 4570 )

iii y y
. Portfolio return Answer: c Diff: M

Calculate bX and bY for the stocks using the regression function of a calculator.

bX = 0.7358; bY = 1.3349.
kX = 7% + 5%(0.7358) = 10.679%.
kY = 7% + 5%(1.3349) = 13.6745%.
kp = 14/20(10.679%) + 6/20(13.6745%) = 11.58%.

k^ p ( $$ 1070 ) ( $$ 2070 ) ( $$ 4070 ) ( $$ 2570 ) ( $$700 ) ( $$ 4570 )

iv y y bX bY . Portfolio return

Answer: b Diff: M

Statement b is correct; all the other statements are false. If the market risk premium increases by 2 percent and k RF
remains unchanged, then the portfolio’s return will increase by 2%(1.08) = 2.16%. Statement a is false, since k p = 6% +
(5%)bp. The portfolio’s beta is calculated as 0.7(1.2) + 0.3(0.8) = 1.08. Therefore, k p = 6% + 5%(1.08) = 11.4%.
Statement c is false. If kRF increases by 2 percent, but RPM remains unchanged, the portfolio’s return will increase by 2
percent. Statement d is false. Market efficiency states that the expected return should equal the required return; therefore,
 k^ p = kp = 11.4%.

( $$ 1070 ) ( $$ 2070 ) ( $$ 4070 ) ( $$ 2570 ) ( $$700 ) ( $$ 4570 )

^
v y y bX bY k p . Portfolio return

Answer: c Diff: M

Find the initial portfolio’s beta and its required return. Then, find the new beta and new required return.
Then subtract the two.

Step 1: The portfolio beta is the weighted average beta of the stocks in the portfolio. The total invested is $70
million ($10 + $20 + $40).

bOld =
( $$ 1070 ) (1.4) +
( $$ 2070 ) (1.0) +
( $$ 4070 ) (0.8)
bOld = 0.9429.

kOld = kRF + (kM – kRF)b

= 5% + (5.5%)(0.9429)
= 10.1857%.

Step 2: Now, change the weights. The amount of X owned is now $25 million ($10 + $15), the
amount of Y owned is now $0 million, and the amount of Z owned is $45 million ($40 +
$5).

bNew =
( $$ 2570 ) (1.4) +
( $$700 ) (1.0) +
( $$ 4570 ) (0.8)
bNew = 1.0143.

kNew = kRF + (kM – kRF)b

= 5% + (5.5%)(1.0143)
= 10.5786%.

Step 3: Now subtract the two returns:

10.5786% - 10.1857% = 0.3929%.