Review of CAPM

1. Review of CAPM • CAPM is a model that relates the required return of a security to its risk as measured by Beta • Benchmark rate for evaluating investments • Provides educated estimate for expected return on assets that have not been traded in the marketplace • Risk premiums are used to compensate investors for systematic risk. The risk premium equal to the asset’s beta times the market risk premium Intermediate Investments F303

2. CAPM Continued • An example using Ford Motor Company • Market risk premium = 8% • Assume Beta for Ford = .75 • What is market risk premium for Ford? • Assume same market risk premium of 8% • Assume following betas • GM .9 • Chrysler .6 • Ford .75 • Assumer weights of • GM = ½ Ford = 1/3 Chrysler = 1/6 • What is Beta and expected return on the portfolio? Intermediate Investments F303

3. CAPM and Alpha • Graph SML and security in equilibrium • Alpha: the abnormal rate of return on a security in excess of what would be predicted by an equilibrium pricing model like CAPM • Under-priced securities have a positive alpha • Over-priced securities have a negative alpha • Expanded CAPM equation = E(ri) = rf + B [E(rm) – rf] + alphai + ei Intermediate Investments F303

4. An Example • Actual average returns for a 15 year period • Franklin Income Fund 12.9% • DJIA 11.1% • Salomon’s High Grade Bond 9.2% • Average return on the market 13.0% • Risk free rate 7.0% • Portfolio Betas • Franklin Income Fund 1.000 • DJIA .683 • Salomon’s High Grade Bond .367 • What are the required returns and alphas for the three portfolios? Intermediate Investments F303

5. Another Example • Assume the following • The market risk premium is 8% • The risk free rate is 3% • Beta of security X is 1.25 • Beta of security Y is .6 • What can you say about security X is th eacutal return is 15%? • What if it is 10%? Intermediate Investments F303

6. A Third Example • Consider the following table: • Beta for the Aggressive stock is 2.00 and for the defensive stock .7 • What is the expected return on each if both scenarios are equally likely? • What does the SML look like if the Risk free rate is 8%? Do the securities have positive or negative alphas? Intermediate Investments F303

7. Uses of CAPM • Use CAPM as a hurdle rate for projects • Use it to determine the cost of capital when pricing stocks in the Dividend Discount Model • Use it to determine the discount rate in capital budgeting problems Intermediate Investments F303

8. In the Dividend Discount Model • The equation for determining stock price using the DDM is P0 = D0 * (1+g) / k – g • Consider the following as the markets stood in 1998 • S&P 500 index is a 1229.23 • Annual dividend was 16.20 • Price/dividend ratio = 75.88 • k as derived from CAPM = 12% • What can you say about the growth rate? What is your required return is 15% Intermediate Investments F303

9. Capital Investment Decisions • Consider an investment project with the following cash flows • Year 0 = -60,000 • Year 1 through t = 15,000 • Expected market return is 12% • Risk free rate is 8% • Beta of the company is 1.5 and the project is equally risky • t = 7 years • What is the required return based on CAPM? • Would you do the project? • What if the project was riskier by a factor of 1.4? Intermediate Investments F303

10. Shortcomings in the CAPM Model • It relies on the theoretical market portfolio • It relies on expected and not actual returns How do we get ‘around’ these? • Use a proxy for the market • Use actual historical returns Intermediate Investments F303

11. Note on Estimating Beta • In theory, over time the value of Beta regresses towards a value of 1 • High betas one period tend to have lower Betas in the future • You can estimate Betas by comparing actual market returns. Consider the following table: • What is the Beta of each of the two assets? Intermediate Investments F303