RETURN AND RISK RELATIONSHIP: CAPITAL ASSET PRICING MODEL

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 rate of return. He has been reading corporate finance books and journal articles to enhance his knowledge on risk/return relationships, capital asset pricing model (CAPM), cost of capital and valuation.

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

R_E = R_F + x (R_M R_F)

where R_E = expected return of the security, R_F = the risk-free rate, = Beta of the security, R_M = the expected return on the market, and (R_M R_F) 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 a 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 learnt that If = 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 = 1, that asset has 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 securitys = 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 any 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.

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.

Year	Return
2014	13.70%
2015	25.80%
2016	35.15%
2017	2.80%
2018	-1.50%

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, 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 1).

4. You want to use 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 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?