A. CAPM

10.25 a)

?Expected Return

Standard Deviation

?Correlation

??Beta

?Firm A

?0.13

0.38

0.47

?0.9

?Firm B

?0.16

0.55

0.40

?1.1

?Firm C

?0.25

0.65

0.35

?1.14

Market Portfolio

0.15

0.20

1

1

?Risk-??free asset

0.05

0

0

0

b)

Using CAPM to find the expected return of each stock, the expected returns are calculated as follows:

Firm A: 14%, Firm B: 16% and Firm C: 16.40%

However the expected returns given in the table are as follows:

Firm A: 13%, Firm B: 16% and Firm C: 25%

Therefore Firm A’s stock is overpriced, Firm C’s stock is underpriced and Firm B’s stock is correctly priced. Therefore the investment recommendation for someone with a well-?? diversified portfolio would be to sell Firm A’s stock and buy Firm C’s stock.

10.27

a) Using CAPM [E(Ri) = Rf +[E(RM)–Rf]? ?i] , the betas for Publicis and Renault can be calculated as follows:

Publicis = 1.27; Renault = 0.64

A portfolio with weights of 57% for Publicis and 43% for Renault would fetch an expected rate of return the same as the CAC 40 (14%). The risk of such a portfolio would be 1 (Beta of 1).

b) A portfolio consisting of weights of 64% of CAC 40 and 36% of the risk free asset would produce an expected return of 10%. The risk of this portfolio (combined standard deviation) would be 10.88%, which is far less than the standard deviation of Renault at 20%, despite

?1

?Renault providing the same expected return (10%).

12.16

a) The assistant’s argument that the cost of equity amounts to 0.55%, based on dividing the dividend per share by the market price per share, is incorrect. This is because he/she is only considering the dividend yield component of the required return on equity. The stock appreciation aspect of the required return on equity has been ignored.

b) The assistant’s calculation of the cost of debt being 2.32% is invalid on two counts-?? i) This represents current yield only and not the yield to maturity…

Capital Markets