Capital Asset Pricing Modfel slp - Assignment Example

CAPITAL ASSET PRICING MODEL Beta is a measure of systematic risk or volatility of a portfolio or a security when compared to themarket in entirety. It is a tendency of the returns of a security to respond to the swings and fluctuations in the market. It shows the risk that arises from exposures to general market movements rather than idiosyncratic factors (Reilly & Brown, 2012). Beta measures the risks of investments that cannot be diversified away in any way. It measures the amount of risks that an investment adds to a portfolio that is already diversified and not investment risks that are held on a stand-alone basis.

However, in the CAPM (capital asset pricing model), beta risk denotes the only type of risk for which an investor should receive an expected return that is greater than the risk-free rate of interest (Ehrhardt & Brigham, (2009).The estimated beta coefficient of Apple Inc. is 1.25. A beta of higher than one generally implies that the price of stock of such a company is both more volatile and tends to move up and down with the market. For instance, like in the case of Apple Inc. A stock’s beta of 1.

25, theoretically implies that the security is 25 percent more volatile than the market. Such stock is riskier than the market. Even though it poses more risk, the stock should be included in the overall portfolio because it offers the possibility of a greater rate of return. This is so because a beta value of 1.25 indicates that the security is anticipated to do 25% better than the S&P 500 within an up market. This stock should be included in the portfolio to help diversify it due to its high risk-reward ratios (Bradfield, 2007).

Capital Asset Pricing Model (CAPM) refers to an economic model that is used to value securities, stocks, assets or derivatives by relating risk and expected return. It is based on the principle that investors demand a risk premium, additional expected return, in case they are required to accept additional risk. CAPM is, therefore, used in pricing stocks or securities (Ehrhardt & Brigham, (2009).The formula is Kc = RF + beta x (Km - RF),Where,Kc is the Cost of Capital;RF is the risk-free rate of return,Km is the market rate of returnFrom the above case, the present cost of equity is calculated using the above formula as follows:Kc = 4.

5% + 1.25 x (6.5),Kc = 12.625%Cost of equity or expected rate of return refers to the rate of return that an investor requires before being interested in any given investment at a particular price. It is the rate of return that compensates them for a higher expected risk (Reilly & Brown, 2012).Calculation of portfolio betaCompany BetaApple Inc. 1.25Facebook 0.74Wal-Mart Stores, Inc. 0.45a) Portfolio beta =1/3*1.25 + 1/3*0.74 + 1/3*0.45= 0.814.b) Portfolio expected rate of return=Facebook’s Kc = 4.

5% + 0.74 x (6.5) = 9.31%Wal-Mart’s Kc = 4.5% + 0.45 x (6.5) =7.425%Portfolio expected rate of return =1/3*12.625 + 1/3*9.31 + 1/3*7.425= 9.786%.The portfolio is sufficiently diversified; because it has a beat of less than one meaning the assets move in the same direction however the movement is less than that of the benchmark hence less susceptible to everyday fluctuation (Bradfield, 2007).ReferenceReilly, F. K., & Brown, K. C. (2012). Investment analysis and portfolio management.

Mason, Ohio: South-Western Cengage Learning.Ehrhardt, M. C., & Brigham, E. F. (2009). Corporate finance: A focused approach. Mason, Ohio: South-Western/Cengage Learning.Bradfield, J. (2007). Introduction to the economics of financial markets. New York: Oxford University Press.