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?

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?

ANSWER

BASED ON CAPM,

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

Required return = 0.07 + (0.12 – 0.07)(1.67) = 0.1538, or 15.38%

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

(a) If the analysts’ expectations are correct, which stocks (if an) are overvalued? Which (if
any) are undervalued?

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

STOCK EXPECTED REQUIRED RTN (SML)

RTN,ER

STOCK 1 17.0% 10%+(15%- UNDERVALUED

10%)x1.3=16.3% ER above SML line

STOCK 2 14.5% 10%+(15%- UNDERVALUED

10%)x0.8=14.0% ER above SML line

STOCK 3 15.5% 10%+(15%- NEUTRAL

10%)x1.1=15.5%

STOCK 4 18.0% 10%+(15%- OVERVALUED

10%)x1.7=18.5% ER below SML line

Expected return > required return 🡺 undervalue

Expected return < required return 🡺 overvalue

The (a) panel, for a 10% risk-free rate and a 15% market return, indicates that stocks
1 and 2 are undervalued while stock 4 is overvalued. Stock 3 is priced so that its
expected return exactly equals the return required by the market; it is neither
overpriced nor underpriced.

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?

Required return ke =10% +(15%-10%)X1.08= 0.10 + (0.15 – .10)(1.08)

= 0.10 + .054 = 0.154 or 15.4 %

Ke= 15.4 %, g=11% , D1=RM 2

Assuming that the perpetual dividend growth model is appropriate, we get

V = D1/(ke – g) = RM2/(0.154 –0.11) = RM2/0.044 = RM 45.45

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).
ANSWER :
Assuming all market risk is borne by equity holders (i.e. the beta of debt is zero), the
relationship between the beta of geared and ungeared equity is :
Using CAPM, Ke= Rf + (Rm-Rf) beta
With 100 % equity or ungeared, the cost of equity is
Ke= 6% + (14% - 6%) x 0.85 = 12.8%

6. Mr. Rich owns a portfolio consisting shares of five public listed firms. The details of
these 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.

Rf= 0.07
Rm – Rf = 0.15-0.07= 0.08 market ridsk premium
Beta = 0.75

Total value of 5 stocks = 22k+45K+33K+24k+52k=176000

Portfolio beta is the weighted average of individual beta

Weight is the percentage of fund invested in each of the stock

The portfolio beta of 1.0 reflects a beta coefficient of the market. No ,the portfolio is not riskier
than the market. This portfolio now carries as much systematic risk as the stock market. Mr.
Rich has managed to reduce the systematic risk of his investment portfolio through his
allocations diversification.