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RETURN AND RISK RELATIONSHIP: CAPITAL ASSET PRICING MODELThe CFO of Bunyan Lumber Corporation, Anita Rai has decided to invest some money in the financial market
RETURN AND RISK RELATIONSHIP: CAPITAL ASSET PRICING MODELThe CFO of Bunyan Lumber Corporation, Anita Rai has decided to invest some money in the financial market to diversify the risks of business operations and increase rate of return. She has been reading corporate finance books and journal articles to enhance her knowledge on riskreturn relationships, capital asset pricing model CAPM cost of capital and stock valuation. On riskreturn relationship, Anita 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:RE RF x RM RFwhere RE expected return on the security, RF the riskfree rate, 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 riskfree rate, also known as the market risk premium.According to the CAPM, the expected return of any security depends on its risk measured by its beta. Anita found out that the beta is a measure of the risk of a security arising from exposure to general economic and market movements ie systematic risk as opposed to business specific risks or factors ie 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 Anita learnt that If then the asset has no risk of financial loss. Therefore, the expected return of the security should be equal to the riskfree rate. If 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 market index. To Anita this makes sense because the beta of the market portfolio is exactly However, if a securitys then that security is twice riskier than the market and the expected return should be higher than the return of the market portfolio. Anita understands that the riskfree rate used in the CAPM is the governmentissued 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 riskfree rate in order to induce any investor to invest in that security. Anita is considering the stock of Aardvark Enterprises and Zebra Enterprises. Aardvark Enterprises has a beta of and Zebra Enterprises has a beta of The riskfree rate is and the difference between the expected return on the market and the risk free is The board of directors of Bunyan Lumber Inc. is hiring you as a financial consultant to work with Anita to analyze the investment options. Based on the beta of Aardvark Enterprises and Zebra Enterprises, which one of the two companies has a higher market risk? Explain Assuming the stock market is expected to do very well because of recent positive economic news and announcement of higher GDP figures, which company, Aardvark Enterprises or Zebra Enterprises, is expected to do better, and why? Using the capital asset pricing model, calculate the expected return for Aardvark Enterprises and Zebra Enterprises stocks if the return on the stock market is You want to calculate the average return of Aardvark Enterprises to see how the stock has performed over the past five years:Exhibit : Historical Returns of Aardvark Enterprises.YearReturna Using the historical returns above, what is the average return for Aardvark Enterprises stock? You notice that stock returns fluctuate daily in the financial market making it risky to invest in stocks. You want to use standard deviation, to assess the volatility of Aardvark Enterprise stock if mean return is and standard deviation is 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 pm You want to use total market return approach to estimate the rate of return on another stock which Anita wants to consider for the investment portfolio. The stock is selling for $ and pays a dividend of $ per share during the year. You think that because of profitable capital investment that the company is undertaken, its stock price will appreciate to $ per share by the end of next year.a Calculate the dividend yield.b Calculate the percentage capital gain of this stock.c Calculate the expected total return of this stock. 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 large number of assets to a greater or lesser degree. And unsystematic risk is a risk that affects specific assets or small group of assets.a List two examples each of systematic risk and unsystematic risk. Anita believes that diversification reduces portfolio risk. She believes that some of the riskiness associated with individual assets can be eliminated by diversification; that is spreading the investment across many assets. She states that the principle of diversification of spreading investment across many assets will eliminate both systematic risk and unsystematic risk. Explain if Anitas statement is correct or incorrect The board of directors wants to know how the following events might cause stocks in general to change price, and whether they might cause Bunyan Lumber stock to change price.a the government announces that inflation unexpectedly jumped by last monthb. the government reports that economic growth rate increases this year by as expectedc. congress approves a surprise reduction in corporate tax rate from to d The CEO of Bunyan Lumber dies in a plane crashExplain to the board the effect of these events on the stock market in general and Bunyans stock. Anita wants you to estimate the weighted average cost of capital WACC for Verizon LLC The IRR computed on a capital project for Verizon is The board wants to see if it will be a good investment. Anita thinks that if IRR WACC then it will be a good investment to consider. The market values for Verizons debt and equity are $ million and $ million respectively. The total value of the firm is $ million, implying that the weight of debt is $ million $ million whereas the weight of equity is $ million $ milliona Estimate WACC for Verizon if the cost of equity is and aftertax cost of debt is Note: WACC Beforetax cost of debt tax rateweight Debt cost of equity weight Equity
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