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The Capital Asset Pricing Model - Essay Example

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Summary
The paper "The Capital Asset Pricing Model" discusses that it is important for investors to know the beta of the stock so that they can make investments as per their risk profile and temperament. The capital Asset Pricing Model is a good way of judging the share from viewpoint of the risk involved…
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The Capital Asset Pricing Model
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Extract of sample "The Capital Asset Pricing Model"

The capital Asset Pricing Model is used by the investors to calculate the required rate of return for stock and that is given as
Ki = RF + bi (KM - RF), where
Ki is the required rate of return, RF is the risk-free return, and bi (beta) is the systematic risk of a stock. (KM - RF), is the equity risk premium that the market would like to earn over the risk-free return in the long run.
Given that
RF = 4.6%
(KM - RF) = 6.4%
Estimating the beta of Oracle (ORCL), using the yahoo.com site, it has been found
bi = 1.42
Now applying the values in the equation to calculate Ki
Ki = 4.6% + 1.42 (6.4) = 13.68%
That means Oracle needs to have a rate of return equivalent to 13.68%.
Calculating for McDonald’s (MCD)
bi = 0.31
Applying the values in the equation to calculate Ki
Ki = 4.6% + 0.31 (6.4) = 6.58%
That means McDonald’s needs to have a rate of return equivalent to 6.58%
Estimating for Bank of America (BAC)
bi = 1.86
Applying the values in the equation to calculate Ki
Ki = 4.6% + 1.86 (6.4) = 16.50%
That means Bank of America needs to have a rate of return equivalent to 16.5%
Estimating for Coca-Cola (KO)
bi = 0.44
Applying the values in the equation to calculate Ki
Ki = 4.6% + 0.44 (6.4) = 7.41%
That means Coca-Cola needs to have a rate of return equivalent to 7.41%
Summarizing, we have the following figures for the rate of returns required for the given stocks.
Oracle =13.68%.
McDonald’s = 6.58%
Bank of America = 16.5%
Coca-Cola =7.41%
Conclusion
The above estimates provide important information to us that the higher the risk associated with the company, the higher the expectation of a return by the investor. In this context, Bank of America is the riskiest company to invest in. That is also demonstrated by its high beta value of 1.86. A beta value of 1.86 essentially indicates that the stock is likely to move up or down concerning the chosen index, in this case, S&P, to the tune of 186%. That means if S&P moves down by 10 percent, BAC will move in the same direction by 18.6%. The reverse is also true when S&P moves up by 10 percent, BAC would also move up by 18.6%. Read More
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