1

2

3

Explain the terms used and the overall meaning of the expression for the expected return on a stock R=Rr+(RmRr) Note: sometimes texts use capital R and sometimes lower case r. Sometimes the expected value of R is expressed as E(R). Sometimes texts will include a subscript j to indicate we are talking about a particular firm j. Make sure you understand that the expected return on a stock - which is obtained from the CAPM model - is also a measure of the opportunity cost of using your money to invest in a similar stock - a measure of the discount rate. In the expression above is the only firm-specific variable. How is it found? Suppose you previously were a family firm with all assets invested in the firm. You then sold out to a set of diversified owners but continued to manage the firm. Would you think that you should change the discount rate that you were previously using? And if so how? The expected return on a stock does not mean that this return is actually being generated. There may be a difference between the actual and the expected in any time period. Interpret the following situation: a stock has an estimated Beta of 0.7 and a current stock rate of return of 7% where the risk-free rate is 5% and the return on the market index is 10%. [Hint: the expected return using the CAPM formula is? The actual return is?]