1 Chapter 13: The Capital Asset Pricing Model Copyright © Prentice Hall Inc Author: Nick Bagley, bdellaSoft, Inc. Objective The Theory of the CAPM Use of CAPM in benchmarking Using CAPM to determine correct rate for discounting

2 Chapter 13 Contents 13.1 The Capital Asset Pricing Model in Brief 13.2 Determining the Risk Premium on the Market Portfolio 13.3 Beta and Risk Premiums on Individual Securities 13.4 Using the CAPM in Portfolio Selection 13.5 Valuation & Regulating Rates of Return

3 Introduction CAPM is a theory about equilibrium prices in the markets for risky assetsCAPM is a theory about equilibrium prices in the markets for risky assets It is important because it providesIt is important because it provides –a justification for the widespread practice of passive investing called indexing –a way to estimate expected rates of return for use in evaluating stocks and projects

4 Specifying the Model We also observed that in the limit as the number of securities becomes large, we obtained the formulaWe also observed that in the limit as the number of securities becomes large, we obtained the formula –This formula tells us that the correlations are of crucial importance in the relationship between a portfolio risk and the stock risk

5 CAPM Formula

Determining the Risk Premium on the Market Portfolio CAPM states thatCAPM states that –the equilibrium risk premium on the market portfolio is the product of variance of the market,  2 Mvariance of the market,  2 M weighted average of the degree of risk aversion of holders of risk, Aweighted average of the degree of risk aversion of holders of risk, A

7 Example: To Determine ‘A’

8 CAPM Risk Premium on any Asset According the the CAPM, in equilibrium, the risk premium on any asset is equal the product ofAccording the the CAPM, in equilibrium, the risk premium on any asset is equal the product of –  (or ‘Beta’) –the risk premium on the market portfolio

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10 Table of Prices

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12 Model and Measured Values of Statistical Parameters

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14 The Beta of a Portfolio When determining the risk of a portfolioWhen determining the risk of a portfolio –using standard deviation results in a formula that’s quite complex –using beta, the formula is linear

15 Computing Beta Here are some useful formulae for computing betaHere are some useful formulae for computing beta

16 Valuation and Regulating Rates of Return Assume the market rate is 15%, and the risk- free rate is 5%Assume the market rate is 15%, and the risk- free rate is 5% Compute the beta of betaful’s operationsCompute the beta of betaful’s operations

17 Valuation and Regulating Rates of Return Beta of betaful’s operations is equal to the beta of our new operationBeta of betaful’s operations is equal to the beta of our new operation To find the required return on the new project, apply the CAPMTo find the required return on the new project, apply the CAPM

18 Valuation and Regulating Rates of Return Assume that your company is just a vehicle for the new project, then the beta of your unquoted equity isAssume that your company is just a vehicle for the new project, then the beta of your unquoted equity is

19 Valuation and Regulating Rates of Return Assume that your company has an expected dividend of $6 next year, and that it will grow annually at a rate of 4% for ever, the value of a share isAssume that your company has an expected dividend of $6 next year, and that it will grow annually at a rate of 4% for ever, the value of a share is