Problem 12-15 Relative Valuation (LO3, CFA2) Suppose you observe the following s
ID: 2807444 • Letter: P
Question
Problem 12-15 Relative Valuation (LO3, CFA2) Suppose you observe the following situation: Security Peat Co. Re-Peat Co. Beta 1.70 0.85 Expected Returrn 13.6 10.8 Assume these securities are correctly priced. Based on the CAPM, what is the expected return on the market? What is the risk-free rate? (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places.) Answer is complete but not entirely correct. Expected return on market Risk-free rate 20.29 x % 88.29x%Explanation / Answer
12-15.
a.
For Peat co.
According to CAPM model:
Expected return = rf + risk premium × beta
13.6% = rf + risk premium × 1.7 ……………………………. (1)
Again
Re-peat
Beta = 0.85
Expected return = 10.80%
Risk free rate = rf
According to CAPM model:
Expected return = rf + risk premium × beta
10.80% = rf + risk premium × 0.85 ……………………………. (1)
Gain Equation 1 – Equation 2
2.8% = 0.85 × Risk premium
Risk premium = 3.29%.
Now risk free rate is calculated below:
Risk free rate = 13.6% - (3.29% × 1.7)
= 13.60% - 5.60%
= 8.00%
Hence, risk free rate is 8.00%
b.
Now market return = Risk free rate + risk premium
= 8.00% + 3.29%
= 11.29%
Hence, Market return is 11.29%.
12-1
Beta = (Expected retun - risk free rate) / Risk Premium
= (15.80% - 3.60%) / 9.90%
= 12.20% / 9.90%
= 1.23
Beta of company is 1.23.