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 assets
beta times the market risk premium

Intermediate Investm

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
Ford .75

.6

Assumer weights of
GM =

Ford = 1/3

Chrysler = 1/6

What is Beta and expected return on the portfolio?

Intermediate Investm

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 Investm

An Example
Actual average returns for a 15 year period

Franklin Income Fund

12.9%
DJIA
11.1%
Salomons 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
Salomons High Grade Bond .367

What are the required returns and alphas for the

three portfolios?
Intermediate Investm

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 Investm

A Third Example
Consider the following table:
Scenario #1
Scenario #2

Market
Aggressive Defensive
5.0%
2.0%
3.5%
20.0%
32.0%
14.0%

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 Investm

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 Investm

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 Investm

Capital Investment Decisions

Consider an investment project with the following cash
flows
Year 0
Year 1 through t

=
=

-60,000
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 Investm

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 Investm

10

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:
r - rf
April
May
June

Market
Asset 1
Asset 2
Exc Ret
Exc Ret
Exc Ret
6.0%
12.0%
3.0%
-4.0%
-8.0%
-2.0%
2.0%
4.0%
1.0%

What is the Beta of each of the two assets?

Intermediate Investm

11