Assumption

• Investors are wealth maximizers who select investments based on expected return and standard
deviation.
• Investors can borrow or lend unlimited amounts at a risk-free (or zero risk) rate.
• There are no restrictions on short sales (selling securities that you don't yet own) of any financial
asset.
• All investors have the same expectations related to the market.
• All financial assets are fully divisible (you can buy and sell as much or as little as you like) and can be
sold at any time at the market price.
• There are no transaction costs.
• There are no taxes.
• No investor's activities can influence market prices.
• The quantities of all financial assets are given and fixed.

Obviously, some of these assumptions are not valid in the real world (most notably no transaction
costs or taxes), but CAPM still works well, and results can be adjusted to overcome some of these
assumptions.
 The Beta Coefficient

• Before we can use the CAPM formula, we need to understand its risk
measurement factor known as the beta coefficient. By definition, the securities
market as a whole has a beta coefficient of 1.0. The beta coefficients of
individual companies are calculated relative to the market's beta.
• A beta above 1.0 implies a higher risk than the market average, and a beta
below 1.0 implies less risk than the market average.
• Most companies' betas fall between 0.75 and 1.50, but any number is possible,
including negative numbers; a negative beta would be highly unlikely, however,
since it would imply less risk than a 'risk free' investment.

For actual use, the beta coefficients of most companies can be found on financial
websites as well as in electronic publications. You can do a quick search to find
companies' beta coefficients.
 Formula and Examples

The CAPM formula is sometimes called the Security Market Line formula and consists
of the following equation:

Expected return* = RF + b(RM - RF)

It is basically the equation of a line, where:

• r* = required return/Expected return

• RF = the risk-free rate

• RM = the average market return

• b = the beta coefficient of the security

• We should also take a moment to talk about the risk-free rate, kRF.
Investments are subject to many risks that may come from the
economy, the nature of the market, the industry in which a company
operates, or the company itself. Of these risk factors, the only one that
is universal is the risk that inflation will decrease an investor's
purchasing power. In theory, the risk-free rate is the return that an
investment with no risks should earn, but in practice it includes the
ever-present risk of inflation.
• Let's calculate a couple of required returns using.Let's hypothetically use a risk free rate of 0.10% and
a market return of 20.63%, respectively. Hypothetically, let's also provide Company R, S, and T with
these current beta coefficients:

• Company R = 0.25

• Company S = 1.82

• Company T = 0.68

• Based on these figures, Company R, with a beta of 0.25, should have a required return of 5.23 or
5.23%.

• Company S, on the other hand, would have a required return of or about 37.46%.

• That's quite a gap, but it reflects the additional risk an investor accepts when investing in Company S
rather than Company R.
 Fair value of stock
• Price of stock= Dividend/Expected return- Growth
• Chicago Corp stock will pay a dividend of
$1.32 next year. Its current price is $24.625
per share. The beta for the stock is 1.35 and
the expected return on the market is 13.5%. If
the riskless rate is 8.2%, what is the expected
growth rate of Chicago?
• Peggotty Services common stock has a β =
1.15 and it expects to pay a dividend of $1.00
after one year. Its expected dividend growth
rate is 6%. The riskless rate is currently 12%,
and the expected return on the market is 18%.
What should be a fair price of this stock?
• Ke = r + βi [E(Rm) − r]
we get ke = 0.12 + 1.15 [0.18 − 0.12] = 0.189
• Thus, the expected return on the stock is
0.189, and the expected growth rate is 0.06.
P0 = 1/ 0.189 − 0.06 = $7.75
• Eastern Oil stock currently sells at $120 a share. The
stockholders expect to get a dividend of $6 next
year, and they expect that the dividend will grow at
the rate of 5% per annum. The expected return on
the market is 12% and the riskless rate is 6%. This
morning Eastern announced that it has won the
multimillion dollar navy contract, and in response to
the news, the stock jumped to $125 a share. Find
the beta of the stock before and after the
announcement.
• Using growth model, P0 = D1/ R − g , we get R
= D1/P0 + g, which is also the expected return
on the stock, E(R).
• But by CAPM, E(Ri) = r + βi [E(Rm) − r]
• Markham Co paid a dividend of $3.00
yesterday, but these dividends are expected to
grow at the rate of 5% in the long run. The
beta of Markham is 0.95, the expected return
on the market is 15%, and the riskless rate is
10% at present. Find the price of one share of
Markham stock.