CAPM

CAPITAL ASSET PRICING

MODEL
CAPITAL ASSET PRICING MODEL
(CAPM)

 A model that describes the relationship between risk and

expected (required) return; in this model, a security’s expected
(required) return is the risk-free rate plus a premium based on the
systematic risk of the security.
BETA
 An index of systematic risk. It measures the sensitivity of a
stock’s returns to changes in returns on the market
portfolio. The beta of a portfolio is simply a weighted
average of the individual stock betas in the portfolio.
 Measures a stock’s market risk, and shows a stock’s
volatility relative to the market.
 Indicates how risky a stock is if the stock is held in a well-
diversified portfolio.
EXAMPLES OF CHARACTERISTICS LINE
WITH DIFFERENT BETAS
BETA

 If Beta = 1.0, the security is just as risky as the average stock.

 If Beta > 1.0, the security is riskier than average.
 If Beta < 1.0, the security is less risky than average.
SECURITY MARKET LINE (SML)

 A line that describes the linear relationship between

expected rates of return for individual securities (and
portfolios) and systematic risk, as measured by beta.
SECURITY MARKET LINE (SML)
CAPM

 William Sharpe
 1970
 Ke (Expected Return) = Rf+β (Rm-Rf)
BETAS FOR SELECTED STOCKS
(JANUARY 13, 2008)
PRACTICE QUESTIONS:

QUESTION NO. 1

The current risk-free rate of return is 4.2%. The market risk 6.6%. Allen
Co. has a beta of 0.87. Using the Capital Asset Pricing Model (CAPM)
approach, Allen's cost of equity is?
PRACTICE QUESTIONS:

QUESTION NO. 2

The current risk-free rate of return is 5%. The market risk premium is
6.6%. Allen Co. has a beta of 1. Using the Capital Asset Pricing Model
(CAPM) approach, Allen's cost of equity is?
PRACTICE QUESTIONS:
QUESTION NO. 3

Use the capital asset pricing model to predict the returns next year of
the following stocks, if you expect the return to holding stocks to be 12
percent on average, and the interest rate on three-month T-bills will be 2
percent. Show your work for three separate calculations.

a. A stock with a beta of -0.3

b. A stock with a beta of 0.7
c. A stock with a beta of 1.6
PRACTICE QUESTIONS:

QUESTION NO. 4

Use A Inc. is considering a vertical merger with The B Company. A

currently has a required return of 11%, while B required return is 15%.
The market risk premium is 5% and the risk-free rate is 5%. Assume the
market is in equilibrium. If A is going to make up % 45 (with B at 33%)
of the new what will be the beta of the newly merged firm? There will be
no additional infusion of debt in the merger.
PRACTICE QUESTIONS:

QUESTION NO. 5

Porter's Inc.'s stock has an expected return of 12.5%, a beta of 1.25, and
is in equilibrium. If the risk-free rate is 2%, what is the market risk
premium?
PRACTICE QUESTIONS:

QUESTION NO. 6

Delta Corp. stock has a beta of 1.3, the current risk-free rate is 3
percent, and the expected return on the market is 12.50 percent.
What is Diddy's cost of equity?