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 apositiverelationship 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 thecapital asset pricing modelin this equation:

R_E=R_F+x (R_M- R_F)

whereR_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 thebetais a measure of the risk of a security arising from exposure to general economic and market movements i.e.systematic riskas 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 security's = 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 thetreasury billhas norisk, any other investment having someriskwill have to have a higherrateof return than the risk-free rate in order to induce any investor to invest in that security.Gregg is considering the stock ofAdobe Inc.andExxon 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 thecapital 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.