Question

2) 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

a.

Capital Assets pricing model

Capital Assets pricing model is the method uses to determine required rate of return of an asset. This method uses, Risk free rate, market return and beta (a measure of market risk) to determine required rate of return on an asset. Market risk premium is calculated by market return and risk-free rate.

Beta is a measure of level of risk in investment. when beta of the company is changed that is level of risk change then the cost of capital of company is also change.

Capital assets pricing model formula for calculation of cost of capital is mention below:

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

b.

Required rate of return is calculated below using CAPM model:

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

= 5% + (10% - 5%) × 1

= 5% + (5% × 1)

= 5% + 5%

= 10%

Based on the CAPM, the required return on an investment in Bubbly over the next 12 months is 10%.

c.

Current Stock price = $50

Expected stock price = $70.

Expected rate of return = ($70 - $50) / $50

= $20 / $50

= 40%

Expected rate of return is 40% and required rate if return is 10%. Since, Expected return is more than required rate of return, so in short term stock price of Bubbly must increase significantly.