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Q: Finance ( Answered 5 out of 5 stars,   0 Comments )
Question  
Subject: Finance
Category: Business and Money > Finance
Asked by: lrdgz-ga
List Price: $10.00
Posted: 18 Sep 2005 12:25 PDT
Expires: 18 Oct 2005 12:25 PDT
Question ID: 569423
Suppose the expected return on a market portfolio is 14.7% and the
risk-free rate is 4.9%.  This company's stock has a beta of 1.3.  If
we assume the CAPM holds, (a) what is the expected return on Solomon's
stock?, and (b) if the risk-free rate decreases to 3.7%, what is the
expected return on the stock?

Clarification of Question by lrdgz-ga on 18 Sep 2005 13:22 PDT
I would appreciate a response within the next couple of hours.  I'll
make it worth your while in a tip!  Thanks in advance for expediting
your response.
Answer  
Subject: Re: Finance
Answered By: omnivorous-ga on 18 Sep 2005 13:40 PDT
Rated:5 out of 5 stars
 
Lrdgz ?

There are several good references to the capital-asset pricing model
on the Internet, including Wikipedia:

Wikipedia
?Capital Asset Pricing Model,? (Sept. 15, 2005)
http://en.wikipedia.org/wiki/Capital_asset_pricing_model



CAPM MODEL
============

The CAPM model says that the return to investors (and to the
corporation, Rc) has to be equal to:
?	the risk-free rate
?	PLUS a premium for stocks as a whole that is higher than the
risk-free rate.  This market return premium is (rM ? rf)
?	And the market return should be multiplied by the risk factor for
the individual company, termed the ?beta of the corporation? (c)


Expressed as a formula, it?s:

Rc = rf + c(rM - rf)

Where,  

Rc is the company's expected return on capital 
rf is the risk-free return rate, usually a long-term U.S. Treasury bill rate 
rM is the expected return on the entire market of all investments. 
Most measures use a common broad index, most often the S&P500 over the
past 5 or 10 years
c is the company's Beta, based on its covariance with the market. 


SOLOMON?S CAPM
================

In the first scenario it is ?

Rc = 4.9% + 1.3 * 9.8% = 17.64%

In the second scenario it is:

Rc = 3.7% + 1.3 * 11 = 18%


There are many assumptions behind the CAPM you may want to note from
the Wikipedia link above.  A critical assumption in this ? with a 1.2%
drop in the T-bill or risk-free rate ? is that market returns don?t
change.  Often lower T-bill rates result in lower Rm numbers.

Google search strategy:
Capital asset pricing model


Best regards,

Omnivorous-GA
lrdgz-ga rated this answer:5 out of 5 stars and gave an additional tip of: $5.00
Wow!  You make it look so easy.  Thanks so much for simplifying it for
me.  I have a couple of other questions I'll be posting shortly.

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