Buisness Finance

* By CAPM, we can get (8.3277%). We can calculate the each of different companies and get the average value. Or we can use CAPM once from average =0.8155. These two results are equivalent.

a. Calculate the expected return over the 4-year period for each of the three alternatives.

5. EverGrow corporation has a beta of 1.10 just paid a dividend of $1.35. The risk-free

Given these approximations, the CAPM model would total the risk-free rate and the market risk premium times beta to arrive at a cost of equity of 9.68%, which reflects the investors’ expected return from investing in shares of the company.

2 Required rate of return on equity is estimated by using CAPM. See Details »

(1) Calculate the expected return (rp), the standard deviation (p), and the coefficient of variation (CVp) for this portfolio and fill in the appropriate blanks in the table.

Solutions to Valuation Questions 1. Assume you expect a company’s net income to remain stable at $1,100 for all future years, and you expect all earnings to be distributed to stockholders at the end of each year, so that common equity also remains stable for all future years (assumes clean surplus). Also, assume the company’s β = 1.5, the market risk premium is 4% and the 20-30 year yield on risk free treasury bonds is 5%. Finally, assume the company has 1,000 shares of common stock outstanding. a. Use the CAPM to estimate the company’s equity cost of capital. • re = RF + β * (RM – RF) = 0.05 + 1.5 * 0.04 = 11% b. Compute the expected net distributions to stockholders for each future year. • D = NI – ΔCE = $1,100 – 0 = $1,100 c. Use the

The historic average returns from 1950 to 1996 and from 1929 to 1996 are given In Exhibit 3. We chose the latter time period as we considered it would give us a more reliable estimate of the risk-free rate by discounting both the Second World War and the Great Depression. It is necessary to evaluate the expected length of the project and utilize a risk free rate applicable for the same time period. Ameritrade is investing $100 million dollars in technology, which is considered a long-term investment, in order to become the largest brokerage firm. We consider their

To test the assumption of a discount rate of 7% as given in the outline of the case, we calculated the required rate of return for the Wal-Mart stock using CAPM . Using rWalMart = Rf + βWalMart [E(RM) – RF], we find the required rate of return to be 7.01% and in line with the information given in the case outline.

1b. if you used the CAPM, which risk premium and risk free rate did you use? Why?

As indicated by the case study S&P 500 index was use as a measure of the total return for the stock market. Our standard deviation of the total return was used as a one measure of the risk of an individual stock. Also betas for individual stocks are determined by simple linear regression. The variables were: total return for the stock as the dependent variable and independent variable is the total return for the stock. Since the descriptive statistics were a lot, only the necessary data was selected (below table.)

3. Calculate the cost of equity capital using the CAPM, assuming a market risk premium of 5%.

Q2. Provide a full-page plot of the Capital Allocation Line for the case in Q1. Label the axes and locate cash, D. Equity, D. Bonds, and your optimal complete portfolio clearly on the plot. You may draw this plot by hand.

Even though there are flaws in the CAPM for empirical study, the approach of the linearity of expected return and risk is readily relevant. As Fama & French (2004:20) stated “… Markowitz’s portfolio model … is nevertheless a theoretical tour de force.” It could be seen that the study of this paper may possibly justify Fama & French’s study that stated the CAPM is insufficient in interpreting the expected return with respect to risk. This is due to the failure of considering the other market factors that would affect the stock price.

The remaining alternatives for this client are to invest in U.S. Rubber, a market portfolio, and a 2-stock portfolio of High Tech and Collections. The expected rates of return are 9.8% in U.S. Rubber, 10.5% in a market portfolio, and 6.7% in the 2-stock portfolio.