The Capital Asset Pricing Model - Essay Example

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