pital Asset Pricing Model and state its assumptions (a) Describe the Ca (b) Shar
ID: 2619326 • Letter: P
Question
pital Asset Pricing Model and state its assumptions (a) Describe the Ca (b) Shares M and N lie on the security market line. (6 Marks) Share M 18% Share N 22% 1.5 Expected return (Assume CAPM holds) Required less rate of return and the risk premium on the market index portfolio? happen to the price and return on shares in P? happen to the price and returns on shares in Q? (Gi) Share P has an expected return of 30 percent and a beta of 1.7. What is likely to (4 Marks) (5 Marks) (iii)Share Q has an expected return of 10 percent and a beta of 0.8, what is likely to (5 Marks) A firm is considering investing in a project with the following cash flows: Net cash flows (Tshs million) 1.000 1,500 2,000 1,750 1,500 1,000 500 500 Year 2 3 4 5 The initial investment is Tshs 6.25 million. The firm has a required rate of return 10 percent. Calculate a) the payback period; b) the discounted payback; c) The net present value. ) Why are capital budgeting decisions so important to the success of a firm? (5 Mark (5 Mark (5 Mark (5 MarlExplanation / Answer
beta is 1 therefore market return=18%
for beta is 1.5,
required return=risk free+1.5*(market return -risk free)=risk free+1.5*(market return -risk free)
=27%-0.5*riskfree
=>27%-0.5*riskfree=22%
=>risk free=10%
hence, risk premium=18%-10%=8%
Share P required return=10%+1.7*8%=23.6%
as expected retrun is more than required return, it is undervalued and hence people will start buying P hence price of P will rise and return will fall
Share Q required return=10%+0.8*8%=16.4%
as expected retrun is less than required return, it is overvalued and hence people will start selling Q hence price of Q will fall and return will rise
payback period=4 years (in year 4 cumulative cash flows=0 as -6.25+1+1.5+2+1.75=0)
discounted payback period=(cumulative discounted cash flows till year 5: =-6.25+1/1.1+1.5/1.1^2+2/1.1^3+1.75/1.1^4+1.5/1.1^5=-0.47195454 cumulative discounted payback=5+0.47195454/(1/1.1^6)=5.836 years)
npv=-6.25+1/1.1+1.5/1.1^2+2/1.1^3+1.75/1.1^4+1.5/1.1^5+1/1.1^6+0.5/1.1^7+0.5/1.1^8=0.58 million
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