Capital Asset Pricing Model and Answer Score Explanation Essay example

Capsim Success Measures RETURN ON EQUITY (ROE) Formula Description: What Does Return On Equity Tell You? Return on equity (ROE) is net profit divided by total equity.

When a state of probability remains undetermined, we often feel compelled to define it. We desire certainty, so we obtain it through whichever way we see fit, even when it is unattainable or harmful to do so. When we imagine

As a deep-discount brokerage, Ameritrade planned to improve its competitive position by price cutting, technology enhancements, and increased advertising in mid-1997. Before initiating the plan, Ameritrade needed know whether the investment returned more than it cost. We were hired to estimate the cost of capital correctly. The key question is to find suitable comparable firms to estimate Ameritrade’s asset beta, since it was a recently-listed firm. We thought discount brokerage companies were best due to same revenue resources. Proper risk-free rate and market risk premium should also be chosen carefully, and we used 30-year bonds YTM and the annual return difference

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.

9. (10 points) You are provided with the following monthly expected returns, each of which is represented by E(Ri), and betas for the following stocks. Please estimate the capital asset pricing model and draw conclusions about the significance and realism of the results. (Note: Please use conventional tests of the R-squared and coefficients.) On the basis of your results, please name at least three of the stocks that you would recommend as “buys.”

CAPM is a model that describes the relationship between risk and expected return, and the formula itself measures the expected return of the portfolio. Mathematically, when beta is higher, meaning the portfolio has more systematic risk (in comparison to the market portfolio), the formula yields a higher expected return for the portfolio (since it is multiplied by the risk premium and is added to the risk free interest rate). This makes sense because the portfolio needs to

Cost of Equity = Risk free rate + (Market return – risk free rate) X beta

Risk free rate + Equity Beta * (Expected return on market - Risk free rate)

Risk Free Rate:       The six-month and 30-year treasury rates given imply a fairly flat yield curve. Due to the relatively short forecast period and the short-term risk characteristics of this industry, the model uses the six-month rate as the risk free rate in calculating the cost of equity.

Utilizing the fundamental concepts of the Capital Asset Pricing Model (CAPM), the expected return for Wal-Mart stock is 7.01% [E(R)]. This is a result of a risk-free rate (Rf) of 3.68%, which was the provided 10-year government bond yield to use as a proxy for the risk-free rate. The beta (β ) of Wal-Mart was 0.66 according to the provided Bloomberg beta estimate. Additional data was provided on the U.S. market risk premium [E(RM) – Rf] of 5.05%. In following the general concepts of CAPM, there are some general assumptions: no transaction costs, all assets are publicly traded,

CAPM results can be compared to the best expected rate of return that investor can possibly earn in other investments with similar risks, which is the cost of capital. Under the CAPM, the market portfolio is a well-diversified, efficient portfolio representing the non-diversifiable risk in the economy. Therefore, investments have similar risk if they have the same sensitivity to market risk, as measured by their beta with the market portfolio.

According to the CAPM model:R_i=α+βR_m+ε, α represent the abnormal return gained by the portfolio. If the market is efficiency, the α has to be zero.

Both firms are expected to generate cash flows of $50 million per year for the foreseeable future and the market value of the equity of ABC, Inc is $500 million. Estimate the return on equity of XYZ, Inc. Assume there are no taxes, and the risk-free rate is 4%. (No more than two decimals in the percentage interest rate, but do not enter the % sign.)

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

These three pieces of the CAPM each cause more confusion. When thinking about the risk free rate one must decide whether or not they will use a long or short term rate. The difference between realized returns on the 90 day T-bill and the ten year T-bond has averaged 150 basis points which can make a difference on the cost of equity and the WACC. Even though the short term risk free rate is more consistent with the CAPM the long term bond more closely reflect the default holding period returns available on long lived investments and this more closely reflects the types of investments made by companies. It’s because of this reason that the survey shows that 70% of the surveyed corporations and financial advisers would rather the long term Treasury bond. However, the text books showed heavy favor towards the short term T-Bill.