CAPM Required Return 0 Expected Rate of

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					Required Return




                  0
    Expected Rate of Return E(r)
   The expected rate of return is the return required
    by equity investors given the risk of the cash
    flows from the firm
       Business risk - a risk that influences a large
        number of assets. Also market risk/systematic risk
        e.g. inflation
       Financial risk - a risk that affects at most a small
        number of assets . Also asset specific
        risk/unsystematic risk
   There are two major methods for determining
    the cost of equity
       Dividend growth model
       SML or CAPM
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            The SML Approach
   Use the following information to compute our the
    expected rate of return E (r )
       Risk-free rate, Rf
       Market risk premium, E(RM) – Rf
       Systematic risk of asset, 




         E (r )  R f   E ( E ( RM )  R f )

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Advantages and Disadvantages
           of SML
   Advantages
       Explicitly adjusts for systematic risk
       Applicable to all companies, as long as we can
        estimate beta
   Disadvantages
       Have to estimate the expected market risk premium,
        which does vary over time
       Have to estimate beta, which also varies over time
       We are using the past to predict the future, which is
        not always reliable


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      Beta of a Portfolio p
 p = W1   1 + W2 2 …..

W = weightage of the individual asset in the
 portfolio
 = risk of the asset




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posted:6/6/2012
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