PreF18_FIN462_Topic_5_CAPM.pdf

# E r a 5 1 5 7 15 5 e r b 5 2 1 7 19 7 i what is the

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E [ r A ] = 5 %+ 1 . 5 × 7 % = 15 . 5 % E [ r B ] = 5 %+ 2 . 1 × 7 % = 19 . 7 % I What is the beta of her portfolio β = 0 . 6 × 1 . 5 + 0 . 4 × 2 . 1 = 1 . 74 I Based on the CAPM and given her portfolio beta, what is the expected return on her portfolio? E [ r P ] = 0 . 6 ( 15 . 5 %)+ 0 . 4 ( 19 . 7 %) = 17 . 18 % E [ r P ] = 5 %+ 1 . 74 × 7 % = 17 . 18 %

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Project Evaluation I TEXT Inc. is a firm with no liabilities and a factory that prints finance textbooks. I TEXT is a publicly traded company whose stock has a market beta of 0.7. I Suppose you estimate that the market equity premium, E [ r M ] - r f , is 8%. The risk-free rate is 3%. I The CEO of TEXT is deciding whether to double the capacity of the factory which would increase the expected value of all future revenues by \$10 million. How much would he be willing to pay for the increased capacity? I The market requires a rate of return of: E ( r ) = r f +( E [ r M ] - r f ) × β = 0 . 03 +( 0 . 08 ) × 0 . 7 = 8 . 6 % Value of Perpetuity = C / r = \$ 10 mil / 0 . 086 = \$ 116 , 279 , 070
Performance Evaluation I The CAPM is useful in evaluating the past performance of a portfolio manager. I If the realized return of a stock/portfolio is higher than that predicted by the CAPM, then the manager found value: The difference is called alpha. E ( r i ) - r f = α +( E [ r M ] - r f ) × β i I If the CAPM holds, what is the expected alpha of any stock or portfolio?

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Capital Asset Pricing Model (CAPM) Example: Suppose that the market premium is 9%, and the risk-free rate is 2% (so the market return is 11%). If a portfolio has a beta of .8, what would you expect its return to be? If the stock actually returned 10.8%, what is its alpha?
Criticisms of CAPM I Investors care about total returns, not just returns on their investments.

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