CAPM

Question 1

What is the objective of CAPM?

Answer 1

Maximise Shareholder wealth
Rational Shareholders hold diversified portfolios
Can set Required return on a project

Question 2

What is business risk?

Answer 2

Risk resulting from business activity (Asset Beta)

Question 3

What is financial Risk?

Answer 3

Risk from gearing levels (Equity beta)

Question 4

Does Beta Asset represent;

1) systematic risk; or
2) systematic risk and company specific financial structure

Answer 4

1) Systematic Risk

Question 5

Does Beta Equity represent;

1) systematic risk; or
2) systematic risk and company specific financial structure

Answer 5

2) systematic risk and company specific financial structure

Question 6

What are the 3 steps to finding the Ke of a new project?

Answer 6

1. De-gear the equity beta of a proxy company to find the asset beta.
2. Using the asset beta, re-gear using the investing companies financial structure
3. Use the re-geared beta to find the Ke.

Question 7

What are the assumptions of the CAPM model?

Answer 7

Well diversified investors
Perfect capital markets
Unrestricted borrowing/lending at a risk free rate
All forecasts made in a single period transaction horizon

Question 8

Of the following assumptions, which two are reasonable?

Well diversified investors
Perfect capital markets
Unrestricted borrowing/lending at a risk free rate
All forecasts made in a single period transaction horizon

Answer 8

Well diversified investors

Forecasts made within a single period transaction horizon - holding periods are usually a year. Returns quoted on a annual basis.

Question 9

What are the Weaknesses of CAPM?

Answer 9

Less useful if investors are un-diversified
Ignores tax of individual investors
Actual data inputs are estimates and hard to obtain

Question 10

What are the strengths of CAPM?

Answer 10

Focuses on systematic risk
Works well in practice - gives a market bases assessment of risk
Useful for specific project appraisal.