1. Capital Asset Pricing Model (CAPM)  allows investors to determine a return on a
project given a project's risk, market return, and a risk free investment
 Estimate returns on risky assets
 Prices adjust to supply and demand
 Uses indexing
 Indexing  holding a portfolio in the same proportions as a market index
 S&P 500
 Calculate risk premium on securities
 Optimal Portfolio is to hold a combination of risky securities as the market portfolio
 Capital Market Line (CML)
 Point F  risk free asset
 Point M  market portfolio
 In equilibrium, CML represents the best riskreward combination for all investors
 Notation
 Expected return on project is E(r)
 Return for riskfree security is r_{f}
 Expected return on portfolio m is E(r_{m})
 Standard deviation for portfolio m is s_{m}
 Standard deviation is s
 In CAPM, the equilibrium risk premium is:
 A is the degree of risk aversion
 Example
 s_{m}=0.2
 A=2.0
 r_{f}=0.2
 b is the marginal contribution of a security's return to the standard deviation of a market's return
where s_{jm}=cov(security_{j}, market portfolio)
The security market line is graphed as:
 If b_{j} > 1, security's return is greater than market
 If b_{j}<1, security has an average risk
 Benefits
 CAPM has performed better than actively managed portfolios
 Cost less to implement than researching for an active portfolio
Example 1: If market return is 10%, a comparable U.S. government security is 4%, and b = 0.5, what return should the investment or project have?
If a project with a b = 0.5 has a return of at least 7%, then proceed with the project. What if everything was the same except b = 2?
You can include the rate of return into a project's net present value of cash flows. If the net present value is positive, then proceed with the project
Corporate Project
 Pays $100,000 on first day of project
 Company receives cash flow
 Year 1 $45,000
 Year 2 $50,000
 Year 3 $55,000
 At end of Year 3, company sells building for $50,000
 Company has a b = 2.0
Valuation of a Stock Price
 g is the growth rate in dividends
 k is the riskadjusted discount rate
 D_{j} is the stock dividend
 Using CAPM
 r_{f} = 0.04
 b_{steady} = 1.5
 Risk premium is 0.08

Expect the equity premium to be 1% to 8%. Any out of this range may be unrealistic. 

Problems with CAPM
 True betas are unknown
 True expected cash flows from a project are unknown
 True expected returns from investments are unknown
 Historical data
 How far back should the data go
 3 years or 100 years
 World changes; should focus on recent data
 What about the impact of financial bubbles (or stock market crashes)
 Dotcom crash of 2001
 Stock market crash in 1987
 These impact parameters if included
 Predict stock market returns on forecasting dividends
 Higher dividends should result in higher dividends
 Problem  Stock market performed well when dividends were close to zero
 Equity premium
 Historical  stock market earn 3% more than bondholders
 Problem  Use Rule 72
 If the interest rate is 3%, then 72 divided by 3 is 24
 At a 3% interest rate, your money doubles in 24 years
 Problem  why is the purpose of investing in bonds
 Survey of Experts
 Problem  Experts can be wrong
 Example  Recessions  do not ask an economists; economists are the worse at predicting recessions
 CAPM does not distinguish between companies that have low debt or high debts
 If you estimated a CAPM for a corporation
 The corporation issues large amounts of bonds and uses it to buy back stock
 As an investor, the higher debt is worrisome, but CAPM does not reflect it
 Beta tends to be small for large companies and large for small companies
 Some companies may be a good investment
 Beta tends to be high for hightech industries and low for traditional industries
 Some hightech investments were good like Microsoft

Despite problems with the CAPM, 73% of executives use it to evaluate future projects. 

Example 2: If market return is 8%, a comparable U.S. government security is 4%, and b = 1.0, what return should the investment or project have?
What if you believe the inflation rate is 2%, then add this to the project's rate or return, yielding 10%.
What if the following events occur in one year when you invest $10,000?
Outcome 
Outcome (x) 
Probability (p) 
Expected Return 
Project payout 
$10,000 (1 + r) 
0.9 
??? 
Gov. seizes assets 
$0 
0.1 
0% 
This project needs to earn at least:
Using the payout matrix, the project needs a return of:
 Total rate or return for project = 22.2%
 Risk premium = 4%
 Includes the impact of beta
 Risk free rate of return = 4%
 Inflation premium = 2%
 Risk of government seizure = 12.2%
