Ch009 - CHAPTER 9: THE CAPITAL ASSET PRICING MODEL PROBLEM...

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CHAPTER 9: THE CAPITAL ASSET PRICING MODEL PROBLEM SETS 1. 2. If the security’s correlation coefficient with the market portfolio doubles (with all other variables such as variances unchanged), then beta, and therefore the risk premium, will also double. The current risk premium is: 14% – 6% = 8% The new risk premium would be 16%, and the new discount rate for the security would be: 16% + 6% = 22% If the stock pays a constant perpetual dividend, then we know from the original data that the dividend (D) must satisfy the equation for the present value of a perpetuity: Price = Dividend/Discount rate 50 = D/0.14 D = 50 × 0.14 = $7.00 At the new discount rate of 22%, the stock would be worth: $7/0.22 = $31.82 The increase in stock risk has lowered its value by 36.36%. 3. a.False. β = 0 implies E(r) = r f , not zero. b. False. Investors require a risk premium only for bearing systematic (undiversifiable or market) risk. Total volatility includes diversifiable risk. c. False. Your portfolio should be invested 75% in the market portfolio and 25% in T-bills. Then: (0.75 1) (0.25 0) 0.75 P β = × + × = 4. The expected return is the return predicted by the CAPM for a given level of systematic risk. $1 $5 ( ) [ ( ) ] ( ) .04 1.5 (.10 .04) .13 13% ( ) .04 1.0 (.10 .04) .10 10% i f i M f Discount Everything E r r E r r E r E r = + × - = + × - = = = + × - = = 9-1 ( ) [ ( ) ] .12 .18 .06 [.14 .06] 1.5 .08 P f P M f P P E r r E r r = + × - = + × - = =
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5. According to the CAPM, $1 Discount Stores requires a return of 13% based on its systematic risk level of β = 1.5. However, the forecasted return is only 12%. Therefore, the security is currently overvalued. Everything $5 requires a return of 10% based on its systematic risk level of β = 1.0. However, the forecasted return is 11%. Therefore, the security is currently undervalued. 6. The expected return of a stock with a β = 1.0 must, on average, be the same as the expected return of the market which also has a β = 1.0. 7. Beta is a measure of systematic risk. Since only systematic risk is rewarded, it is safe to conclude that the expected return will be higher for Kaskin’s stock than for Quinn’s stock. 8. The appropriate discount rate for the project is: r f + β × [E(r M ) – r f ] = .08 + [1.8 × (.16 – .08)] = .224 = 22.4% Using this discount rate: × + - = + - = = 15 [$ 40 $ 224 . 1 15 $ 40 $ NPV 10 1 t t Annuity factor (22.4%, 10 years)] = $18.09 The internal rate of return (IRR) for the project is 35.73%. Recall from your introductory finance class that NPV is positive if IRR > discount rate (or, equivalently, hurdle rate). The highest value that beta can take before the hurdle rate exceeds the IRR is determined by: .3573 = .08 + β × (.16 – .08) β = .2773/.08 = 3.47 9. a.Call the aggressive stock A and the defensive stock D. Beta is the sensitivity of the stock’s return to the market return, i.e., the change in the stock return per unit change in the market return.
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This note was uploaded on 03/23/2011 for the course FIN 301 taught by Professor 3213 during the Three '11 term at Curtin.

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Ch009 - CHAPTER 9: THE CAPITAL ASSET PRICING MODEL PROBLEM...

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