Corporate finance, CAPM, beta equation, practice exam problems
(The attached PDF file has better formatting.)
*Question 1.1: Expected Return
A stock with a CAPM β of 0.800 has an expected return of 12%, and a stock with a CAPM β of 1.200 has an expected return of 14%. What is the expected return for a stock with a CAPM β of 1.500?
15.0%
15.5%
16.0%
16.5%
17.0%
Answer 1.1: B
We use the CAPM equation and a pair of simultaneous linear equations to find the risk-free rate and the market risk premium.
12% = risk-free rate + 0.800 × market risk premium
14% = risk-free rate + 1.200 × market risk premium
A (1.200 – 0.800) × market risk premium = 14% – 12% = 2%
A market risk premium = 2% / 0.4 = 5%
To find the risk-free rate: 12% = risk-free rate + 0.8 × 5% A risk-free rate = 8%
The expected return on this stock is 8% + 1.5 × 5% = 15.5%
*Question 1.2: Betas
The CAPM beta of stock W is 1.200, the CAPM beta of stock Y is 0.800, and the risk-free rate equals the market risk premium. How much greater is the expected return on Stock W than the expected return on Stock Y?
The same
20% greater
22% greater
40% greater
50% greater
Answer 1.2: C
Let the risk-free rate be R, so the market risk premium is also R.
The expected return on Stock W is R + 1.2 × R = 2.2 × R.
The expected return on Stock Y is R + 0.8 × R = 1.8 × R.
The ratio of the expected returns is 2.2R / 1.8R = 1.222