(1) Consider the CAPM The risk-free rate is 5%, and the expected return on the m
ID: 2614299 • Letter: #
Question
(1) Consider the CAPM The risk-free rate is 5%, and the expected return on the market is 15%. What is the beta on a stock with an expected return of 17% (2) You consider buying a share of stock at a price of S25. The stock is expected to pay a dividend of $1.50 next year, and your advisory service tells you that you can expect to sell the stock in 1 year for $28. The stock's beta is 1.1, rris 690, and E[nd-1690. What is the stock's abnormal return? +' (3) You are a consultant to a large manufacturing corporation that is considering a project. +' The project's beta is 1.8. Assuming that r,-8% and End-1696, what is the required rate of return (cost of capital) based on CAPM? Suppose that you estimate that the internal ate of return (RR) of the project is 20%. Should you recommend investing in the project?Explanation / Answer
1) As per CAPM
Required rate = Risk free rate + beta( Market rate of return less Risk free rate of return)
=17% = 5%+ beta(15%-5%)
=17% = 5%+ beta(10%)
12%=Beta(10%)
Beta = 1.2
2) First of all lets calculate required rate
Required rate = Risk free rate + beta( Market rate of return less Risk free rate of return)
=6%+1.1(16%-6%)
=6% + 1.1(10%)
=6%+11%
=17%
Now let us calculate price of stock
Price of stock = D1/Ke
=1.5/17%
=8.82$
Return = 1.5 + (28-8.82) / 8.82
=1.5+19.18 /8.82
=234.43%
3) Required rate as per CAPM = Risk free rate + beta( Market rate of return less Risk free rate of return)
=8%+1.8(16%-8%)
=8%+1.6(8%)
=8%+12.8%
=20.8%
If IRR is 20%, then project should not be accepted
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