RETURN AND RISK RELATIONSHIP: CAPITAL ASSET PRICING MODEL

RETURN AND RISK RELATIONSHIP: CAPITAL ASSET PRICING MODEL

INTRODUCTION

The CFO of Baldwin Corporation, Gregg Williams has decided to invest some money in the financial market to diversify the risks of business operations and increase the rate of return. He has been reading corporate finance books and journal articles to enhance his knowledge of risk/return relationships, capital asset pricing model (CAPM), cost of capital, and valuation.

On the risk/return relationship, Gregg has learned that there is a positive relationship between risk and return. This implies that the higher the risk, the greater the expected return on investment. This relationship is clearly explained by the capital asset pricing model in this equation:

RE = RF + β x (RM – RF)

where RE = expected return of the security, RF = the risk-free rate, β = Beta of the security, RM = the expected return on the market, and (RM – RF) represents the difference between the expected return on the market and the risk-free rate.

According to the CAPM, the expected return of any security depends on its risk measured by its beta. Gregg found out that the beta is a measure of the risk of security arising from exposure to general economic and market movements i.e. systematic risk as opposed to business-specific risks or factors (i.e. unsystematic risk). The higher the beta, the greater the systematic risk and vice versa.

The market portfolio of all investable assets has a beta of 1. Gregg learned that If β = 0, then the asset has no risk of financial loss. Therefore, the expected return of the security should be equal to the risk-free rate. If β = 1, that asset has the same risk as the market and the expected return should equal the expected return on the market such as the S&P 500 market index. To Gregg, this makes sense because the beta of the market portfolio is exactly 1. However, if a security’s β = 2, then that security is twice riskier than the market and the expected return should be higher than the return of the market portfolio.

Gregg understands that the risk-free rate used in the CAPM is the government-issued treasury bill rate. Since the treasury bill has no risk, any other investment having some risk will have to have a higher rate of return than the risk-free rate in order to induce an investor to invest in that security. Gregg is considering the stock of Adobe Inc. and Exxon Mobil. Adobe Inc. has a beta of 1.5 and Exxon Mobil has a beta of 0.8. The risk-free rate is 3%, and the difference between the expected return on the market and the risk-free is 8.0%.

Baldwin Inc. is retaining you as the financial consultant to work with Gregg to analyze these investment options.

TASK

1. Using the capital asset pricing model, calculate the expected return for Adobe Inc. and Exxon Mobil stocks.

2. You want to calculate the average return of Adobe Inc. to see how the stock has performed over the past five years:

Exhibit 1: Historical Returns of Adobe Inc.

(((Please Check Attachment))

a. Using the historical returns above, what is the average return for Adobe Inc. stock?

3. You notice that stock returns fluctuate daily in the financial market making it risky to invest in. You want to use standard deviation, σ to assess the volatility of Adobe Inc. stock if mean return is 15.20% and standard deviation is 12%. What is the possible return of this stock one standard deviation from the mean if the return is normally distributed? (Note: expected return = mean return ± 1σ).

4. You want to use the total market return approach to estimate the rate of return on another stock which Gregg wants to consider for the investment portfolio. The stock is selling for $25 and pays a dividend of $2 per share during the year. You think that because of the profitable capital investment that the company is undertaken, its stock price will appreciate to $28 by the end of next year.

a. Calculate the dividend yield and the percentage capital gain of this stock.

b. What is the expected total return of this stock?

5. You are looking at sources of risk for the investment portfolio and came across systematic risk and unsystematic risk in a financial journal. The systematic risk is defined as any risk that affects the whole economy or a large number of assets to a greater or lesser degree. And the unsystematic risk is a risk that affects specific assets or small groups of assets.

a. List two examples each of systematic risk and unsystematic risk.

6. Gregg wants you to estimate the weighted average cost of capital (WACC) for Verizon LLC. The IRR computed on a capital project for Verizon is 12%. Gregg wants to see if it will be a good investment. He thinks that if IRR > WACC then it will be a good investment to consider. The market values for Verizon’s debt and equity are $40 million and $60 million respectively. The total value of the firm is $100 million, implying that the weight of debt is 40% ($40 million /$100 million) whereas the weight of equity is 60% ($60 million /$100 million). Assume a tax rate of 35% for Verizon.

a. Estimate WACC for Verizon if the cost of equity is 13.32% and cost of debt is 5%. (note: WACC = cost of debt (1 – tax rate) (weight Debt) + cost of equity (weight Equity).

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