Unit 6 Study Guide: Applying the CAPM Model

6a. explain what the CAPM measures and its components
  • What is return?
  • What is the risk-free rate?
  • How does the Capital Asset Pricing Model help to compute return?

The Capital Asset Pricing Model (known as CAPM) is the formula that measures the expected return of a risky asset. The basic components of the CAPM formula are: the risk-free rate on a riskless asset in the US economy, the expected return of the stock market, and the beta of the risky asset. The CAPM allows for the computation of the expected return of a risky security, taking into consideration the stock's beta and the market risk premium, which is the expected return of the entire market minus the risk-free rate. The risk-free rate is the interest rate on a security in the economy that is believed to hold very little risk for investors, which is customarily the rate on the 1-month or 3-month US Treasury Bill. The rate on that security is considered to represent the least amount of risk to investors because the life of the security is so short and because the US government, having the highest credit rating, is almost certain not to default on its obligations.

CAPM Equation:  R_S=R_F+\left [ R+M-R_F \right ]\times \beta

6b. compute a company's expected rate of return using past stock data

  • What is expected return?

The Invest-in-Us firm paid an annual dividend of $0.50 per share last month on a stock that costs $5 per share. Today the company announced that future dividends will be increasing by 3 percent annually. If you require a 12 percent rate of return, how much are you willing to pay to purchase one share of this stock today?

Try to follow this example:

First, find the future dividend for the next period and divide that by current stock price. Then, add to that the expected growth rate and the result is the expected return.

 

 \frac{\left ( \$0.50 \right )\left ( 1+.03 \right )}{\$5.00}+\left ( .03 \right )=13.6\%

Next, compute the difference between the required and expected rates of return.

Required rate of return = 12% Expected rate of return = 13.6% Expected rate - required rate = 13.6% - 12.0% = 1.6%

You would be willing to pay up to 1.6% over the current stock price because that is the value of the expected return compared to what your required return. So ($5.00 × (1 + 0.16)) = $5.08.

Answer: You would be willing to pay a maximum of $5.08 for this stock

6c. apply the results from the CAPM model into net present value calculations
  • What does CAPM calculate?
  • What is Net Present Value?

Using CAPM, calculate the expected return when the risk-free rate of return is 2 percent, the market risk premium is 9 percent, and the beta is 1.

Example:

Expected return of a stock or R_S=R_F+\left [ R+M-R_F \right ]\times \beta , where  R_F is the risk-free rate;  R_M is the return of the market; and  \beta is the beta of the stock.

 R_F = .02

 R_M - R_F = Market Risk Premium = .09

 \beta = 1.0

 R_S = .02 + [.09] \times 1.0 = .02 + .09 = .11 or 11%

The expected return on this stock is 11%.

Now, assume that you will receive $2,000 per year for 5 years, and use the expected return you just calculated as the discount rate. What is the net present value of those cash flows?

Example Continued:

 \mathrm{NPV}=\sum_{t=0}^{n}\frac{CF_t}{\left ( 1+R \right )^t}

 \mathrm{NPV} = \frac{\$2000}{(1+.11)^5} +\frac{\$2000}{(1+.11)^4} + \frac{\$2000}{(1+.11)^3} + \frac{\$2000}{(1+.11)^2} + \frac{\$2000}{(1+.11)^1} = \$7,391.79

6d. recommend financial decisions based on a company's expected rate of return calculation
  • What is the expected rate of return?
  • What is the required rate of return?
  • What is the criteria to determine if a financial investment should be made?

The outcome of CAPM computations can be used to make financial decisions. CAPM is used to compute the expected rate of return for a stock. The answer from the CAPM equation is interpreted as a percent. Firms establish a required rate of return desired from each investment. Once you compute the expected rate of return for an investment, compare that to the firm's required rate of return. If the expected return of the investment is greater than the firm's required return, then the financial investment should be made.

Unit 6 Vocabulary

This vocabulary list includes terms that might help you with the review items above and some terms you should be familiar with to be successful in completing the final exam for the course.

Try to think of the reason why each term is included.

  • Beta
  • Risk
  • Return
  • Required Rate of Return
  • Expected Return
  • Capital Asset Pricing Model
Last modified: Wednesday, July 17, 2019, 5:46 PM