CAPM and Sources of Capital: A Study Guide

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Part I: 1a. Inflation is diversifiable only to the extent that the company can invest in other countries. In general, however, inflation is considered to be a market risk, affecting all firms in the country, and therefore an undiversifiable risk. b. A major recession would be an undiversifiable risk. c. A major lawsuit against a single corporation is a diversifiable risk. 2a. The capital asset pricing model is as follows: INCLUDEPICTURE "http://i.investopedia.com/inv/dictionary/terms/CAPM.gif" * MERGEFORMATINET Â Source: Investopedia Therefore Rm = 10.667 2b. Rf = 5% 2c.If I owned half of all the stocks on major exchanges, I would expect that the portfolio's beta would be 1. It takes only around 30 stocks to have what is considered to be a fully diversified portfolio, so half the stocks would easily be a fully diversified portfolio (Investopedia, 2012). 3. The main message of the capital asset pricing model is that risk and return are related. Under CAPM, the expected return of an asset is directly correlated to the beta, so the higher the beta the higher the expected return of the asset. This is the risk-return relationship. Under CAPM, an investor cannot "beat" the market on a risk-adjusted basis. To corporations, the principle is the same. CAPM is a way to calculate the cost of equity, but again the cost of equity is related to the volatility of the firm's stock price, and therefore a company with a more volatile stock price is one that will have

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