Question

Your sister-in-law, a newly minted graduate just landed her first job with a large research firm. Her first assignment was to come up with an estimate of the change in share price for Bubbly Incorporated over the next twelve months. She estimates the price will rise from $50 to $70 per share over the next year and highly recommends you place a buy order. You recall from your Corporate Finance course that the estimated return and risk are the only parameters that should be considered in the investment decision & have decided to us the CAPM to help you access the desirability of purchasing shares in this firm. Assuming an expected return on the market over the next 12 months of 10%, a risk free rate of 5%, a beta for Bubbly of 1.00 please answer the following questions:

a)Briefly define the CAPM and explain its use in the investment analysis process

b)Based on the CAPM what is the required return on an investment in Bubbly over the next 12 months? Would you make the purchase (why or why not)? c)What would you expect to happen to the stock price of Bubbly in the short term? Why?

Answer 1

Answer (a) CAPM stands for Capital Assets Pricing Model This model is used to know the relationship between risk and return analysis of the security. The risk here is systematic risk This model is introduced by Harry Markowitz in the 1950's.

CAPM is calculated by = Rf+ B {R(m) - Rf }

where Rf is risk free return and the Rm is market return and B is beta which is risk measurement.

The use of CAPM in the investment analysis process is that it helps to determine that what percentage of return who deserve If you take the risk of that level It means the return we deverse on taking the risk.

Ans (b) Based on the CAPM , the required return on an investment in Bubbly over the next 12 months is

= Rf + beta ( Rm-Rf )

= 5 + 1 ( 10 - 5 ) = 10%

But the Return As per bubbly is 20/50 = 40%

Yes i can made the purchase of this stock because here the expected return is more than the CAPM return.

As per me the price of the stock in one year would be $55

because the CUrrent price of stock is $50 and the CAPM return is 10%

so the price of the share after one year is = 50 + 10%(50) = 55$ as per the CAPM return.