We Do Bankruptcies is a law firm that specializes in providing advice to firms i

Question

We Do Bankruptcies is a law firm that specializes in providing advice to firms in financial distress. It prospers in recessions when other firms are struggling. Consequently, its beta is negative, 0.2.

a. If the interest rate on Treasury bills is 4% and the expected return on the market portfolio is 19%, what is the expected return on the shares of the law firm according to the CAPM? (Enter your answer as a whole percent.)

b. Suppose you invested 90% of your wealth in the market portfolio and the remainder of your wealth in the shares in the law firm. What would be the beta of your portfolio? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

Explanation / Answer

Answer 1 Capital asset pricing model is an equation describing the expected return on any asset (or portfolio) as a linear function of its beta relative to the market portfolio.

Expected return= Risk free rate + Beta × (Market Return-Risk free rate)

Expected return of law firm=4-0.2× (19-4)

Expected return=4-0.2×15

Expected return=1%

Answer 2

Beta of Market=1

Beta of portfolio=Weight in Market portfolio× beta of market portfolio + Weight in Law firm× beta of Law firm

Beta of portfolio=0.9×1+0.1× (-0.2)

Beta of portfolio=0.88

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