1) Your sister-in-law, a newly minted graduate just landed her first job with a large research...

1) 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:

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

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)?

What would you expect to happen to the stock price of Bubbly in the short term? Why?

Expert Solution

CAPM known as Capital asset pricing Model helps us in finding the required rate of return for any asset, its components are risk free rate , Risk premium and Beta . Risk free rate showns us that if we dont want any risk in our investment we will be getting the risk free return. Risk premium is difference between Market rate of return and risk free rate. Beta shows with one unit change in risk premium how much it will impact the required return

Required return = risk free rate+Beta*Risk Premium

CAPM is extensively used in investment analysis as it provides minimum return required from any investment and it is comared with the expected return that investment is giving . If expected return is higher than minimum return or not helps is choosing the assets to invest.

Required return for bubbly- 5%+1*(10-5)%=10%

Yes , we could make the investment as the required return in 10% while as per estimation this investment will give 40% return i.efrom $50 to $70 in 12 months

jeff jeffy answered 2 years ago

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