Intermediate Investments F3031 Review of CAPM CAPM is a model that relates the required return of a security to its risk as measured by Beta –Benchmark rate for evaluating investments –Provides educated estimate for expected return on assets that have not been traded in the marketplace –Risk premiums are used to compensate investors for systematic risk. The risk premium equal to the asset’s beta times the market risk premium

Intermediate Investments F3032 CAPM Continued An example using Ford Motor Company –Market risk premium = 8% –Assume Beta for Ford =.75 –What is market risk premium for Ford? –Assume same market risk premium of 8% –Assume following betas GM.9 Chrysler.6 Ford.75 –Assumer weights of GM = ½ Ford = 1/3Chrysler = 1/6 –What is Beta and expected return on the portfolio?

Intermediate Investments F3033 CAPM and Alpha Graph SML and security in equilibrium Alpha: the abnormal rate of return on a security in excess of what would be predicted by an equilibrium pricing model like CAPM Under-priced securities have a positive alpha Over-priced securities have a negative alpha Expanded CAPM equation = E(r i ) = r f + B [E(r m ) – r f ] + alpha i + e i

Intermediate Investments F3034 An Example Actual average returns for a 15 year period –Franklin Income Fund12.9% –DJIA11.1% –Salomon’s High Grade Bond 9.2% –Average return on the market 13.0% –Risk free rate 7.0% Portfolio Betas –Franklin Income Fund1.000 –DJIA.683 –Salomon’s High Grade Bond.367 What are the required returns and alphas for the three portfolios?

Intermediate Investments F3035 Another Example Assume the following –The market risk premium is 8% –The risk free rate is 3% –Beta of security X is 1.25 –Beta of security Y is.6 What can you say about security X is th eacutal return is 15%? What if it is 10%?

Intermediate Investments F3036 A Third Example Consider the following table: Beta for the Aggressive stock is 2.00 and for the defensive stock.7 What is the expected return on each if both scenarios are equally likely? What does the SML look like if the Risk free rate is 8%? Do the securities have positive or negative alphas?

Intermediate Investments F3037 Uses of CAPM Use CAPM as a hurdle rate for projects Use it to determine the cost of capital when pricing stocks in the Dividend Discount Model Use it to determine the discount rate in capital budgeting problems

Intermediate Investments F3038 In the Dividend Discount Model The equation for determining stock price using the DDM is P 0 = D 0 * (1+g) / k – g Consider the following as the markets stood in 1998 –S&P 500 index is a –Annual dividend was –Price/dividend ratio = –k as derived from CAPM = 12% –What can you say about the growth rate? What is your required return is 15%

Intermediate Investments F3039 Capital Investment Decisions Consider an investment project with the following cash flows –Year 0 =-60,000 –Year 1 through t= 15,000 Expected market return is 12% Risk free rate is 8% Beta of the company is 1.5 and the project is equally risky t = 7 years What is the required return based on CAPM? Would you do the project? What if the project was riskier by a factor of 1.4?

Intermediate Investments F30310 Shortcomings in the CAPM Model It relies on the theoretical market portfolio It relies on expected and not actual returns How do we get ‘around’ these? Use a proxy for the market Use actual historical returns

Intermediate Investments F30311 Note on Estimating Beta In theory, over time the value of Beta regresses towards a value of 1 –High betas one period tend to have lower Betas in the future You can estimate Betas by comparing actual market returns. Consider the following table: What is the Beta of each of the two assets?