Question

Here are data on two companies. The T-bill rate is 4% and the market risk premium is 6%.

Company	$1 Discount Store	Everything $5
Forecasted Return	12%	11%
Standard Deviation of Returns	8%	10%
Beta	1.5	1.0

1) What would be the fair return for each company, according to the capital asset pricing model (CAPM)?

2) Explain how the CAPM is used to perform this calculation and how a financial advisor would utilize this information to advise a client.

3) Discuss how changes in expected returns impact company stock prices.

Answer 1

2) The CAPM model is one where the risk is measured in terms of systematic risk Beta. The risk-free rate is added to the equity risk premium for the stock. Equity risk premium is equal to the beta multiplied by the market risk premium. The way financial advisor uses this approach is to use this to compare the forecasted return with the required return on the basis of CAPM model. If the forecasted return is greater than the required rate or expected rate on the basis of CAPM model then we purchase the asset or invest in that asset but if the forecasted return is less than the required rate then we do not go ahead with that investment.

3) The stock price can be significantly affected by the change in the expected return. The formula for the price of the stock is =

Expected dividend/(expected return – growth rate)

So here the relationship between the expected return and the stock price is inverse. If the expected return increases then the value of the share price will decrease and if the expected return decrease then the stock price will increase other things keeping constant.