Chapter 12, Problem 36P

Summary Introduction

Expected return:

Expected return of the market refers to the return earned from the market over and above the risk-free rate of return. Risk-free rate of return, is the return that an investor must demand for inflation and the time-value of money, even when there is hardly any risk of any financial loss. Risk premium varies with the systematic risk in an investment. It is the market risk premium multiplied by the beta (ß) of a security. It is determined as the market risk premium multiplied by the beta of the security. The market risk premium is equal to the expected market return less the return earned from risk-free security.

The expected return can be calculated using the formula given below.

Where,

• is the expected return.
• is the risk free rate of return.
• is the beta of the asset.
• is the expected return of the market.

Beta:

Beta measures the change in percentage in the excess return of a particular security for 1% change in the excess return of a market portfolio or a benchmark portfolio. The beta of a market portfolio is always 1. However, the securities may have either higher or lower betas as compared to the beta of the market portfolio. The primary reason for this difference is the sensitivity of the individual industries to the economy.

The beta of a portfolio is the weighted average beta of the overall stocks in a portfolio.

The beta of a portfolio with three stocks, Stock E, Stock C, and Stock K can be calculated using the formula given below.

Where,

• is the beta of a portfolio.
• is the weight of a stock.

(a)

To determine:

Whether Company A’s managers exceed their investors’ required return as given by the CAPM.