Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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Risk and return
Before understanding the concept of Risk and Return in Financial Management, understanding the two-concept Risk and return individually is necessary.
Capital Asset Pricing Model
Capital asset pricing model, also known as CAPM, shows the relationship between the expected return of the investment and the market at risk. This concept is basically used particularly in the case of stocks or shares. It is also used across finance for pricing assets that have higher risk identity and for evaluating the expected returns for the assets given the risk of those assets and also the cost of capital.
Question
What is the expected return on the firms stock
Transcribed Image Text:Question 1
You are the CFO of a large, Danish company that manufactures bulletproof vests. You are appointed
by the board of directors to serve the interest of the shareholders. As the CFO, you are considering to
invest in the development of a new line of vests known as the Mariachi Vest. You know little about
company, except that it is a firm traded on Nasdaq OMX, and its stock is quite risky according to
the estimated beta of the firm, which is 1.60. Thus, the first thing you do when you start your analyses
is to look at the financial statements of the firm. You see that it is 75% financed by debt, and debt
holders require a 5% rate of return on their investment. The cost of constructing the plant for
developing the vest is DKK 50,000,000 upfront. The plant then would have an expected life of 10
years. The firm expects to sell 4000 vests a year till the plant closes down. All the expenditure made
for the plant today will be depreciated straight-line over 10 years (from year 1 to year 10) to a salvage
value of 10 million DKK, but they expect to sell the plant after 10 years for 15 million DKK. If it
works, it will generate DKK 7,000,000 per year for 10 years. Taxes are 21%. The interest on short-
term government bonds is 4%, while the overall Nasdaq OMX stock market returned 8% last year and
that is expected to continue. Also, importantly, you quickly realize that this project is a typical
investment project of your company ?.
the
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