Question 1

Suppose the rate of return on short-term government securities (perceived to be risk-free) is 5%. Suppose also that the expected rate of return required by the market for a portfolio with a beta of 1 is 12%. According to the capital asset pricing model (CAPM):

a) What is the expected rate of return on the market portfolio? (2 marks)

b) What would be the expected rate of return on a stock with = 0? (2 marks)

c) What is the risk premium on the market portfolio? (2 marks)

d) Suppose you consider buying a share of XYZ stock at $40. The XYZ stock is expected to pay $3 dividends next year and after that you actually expect it to sell for $41. The beta of the XYZ stock risk has been evaluated at = 0.5. Is the XYZ stock overpriced, fairly priced, or underpriced? Explain your answer. (4 marks)

e) A firm considers an investment project that has an estimated beta of 1.3.

i) What is the required rate of return on the investment project? (3 marks)

ii) If the actual expected internal rate of return (IRR) of the investment project is 11%, should the firm accept the project? Explain your answer. (3 marks)

iii) Is the investment project a better investment than the XYZ stock in part d) according to the CAPM? Explain your answer. (4 marks)