When calculating expected return [E®] for a risky asset, is there any instance when we should use the formula: Ri = a + bRm + e, rather than: E® = RFR + B(Rm - RFR) ? where: Ri = return for asset i a = y-intercept b = slope Rm = return for market portfolio [Above pertains to Vol. 4, reading 51, EOC problems 7 and 8. If there is any error in the solutions, it does not appear in the errata.] Any clarification would be appreciated! Thanks.
No. What made you think about using the first formula? Both questions just require us to identify whether the stock is over valued, under valued or properly valued and therefore we will use SML equation to calculate the expected rate of returns. If the expected return coming out is greater than the estimated return then the stock will be overvalued and if not then vice versa.
SpyAli Wrote: ------------------------------------------------------- > No. What made you think about using the first > formula? > > Both questions just require us to identify whether > the stock is over valued, under valued or properly > valued and therefore we will use SML equation to > calculate the expected rate of returns. If the > expected return coming out is greater than the > estimated return then the stock will be overvalued > and if not then vice versa. Understood. My only confusion is the text’s reported value for expected return. The solution to Problem 7 ( Reading 51) reports the expected return on the stock as E® = 12.8%. However, using the equation E® = RFR + B(Rm - RFR) yields a value of 8.4%. [given: Rm = 8%, RFR = 4%. B(beta) = 1.1] Am I missing something? Thanks!
I think the problem gave you ERP=Equity Risk Premium = RM-RF = 8% 4 + 1.1*8 = 12.8% and not RM=8% as u have interpreted. That is a frequent source of confusion… watch out for that trap.
cpk123 Wrote: ------------------------------------------------------- > I think the problem gave you ERP=Equity Risk > Premium = RM-RF = 8% > > 4 + 1.1*8 = 12.8% > > and not RM=8% as u have interpreted. > > That is a frequent source of confusion… > > watch out for that trap. Correct !! @defone: Whenever you see the word “premium” in such questions it stands for (Rm-Rf) as a whole. So you don’t need to subtract Rf again from it. You will come across plenty of such questions in practice.
cpk123 Wrote: ------------------------------------------------------- > I think the problem gave you ERP=Equity Risk > Premium = RM-RF = 8% > > 4 + 1.1*8 = 12.8% > > and not RM=8% as u have interpreted. > > That is a frequent source of confusion… > > watch out for that trap. ^ Correct, guys. Complete misreading on my part; the market risk premium (Rm - RFR) was already given. Probably the important thing to keep in mind: read every word in the question, not just what is being asked. Thanks.
Please can anyone take a shot at these questions. Thanks. #1. Sally Andrews salary next year is expected to be $40,000. Assume she expects her salary to grow at a steady rate of 4% per year for another 25 years. If the appropriate cost of capital (aka discount rate) is 9%, what is the PV today of Sally’s future salary cashflow stream? [For simplicity, assume the salary amounts are at the end of each of the next 25 years.] Answer to nearest $1000. a. 246,000 b. 247,000 c. 391,000 d. 553,000 e. 800,000 #2. You have the opportunity to buy a note for $10,000. The note is certain to pay $2000 at the end of each of the next 10 years. If you buy the note, what rate of interest will you receive on this investment (to nearest %) a. 15% b. 100% c. 20% d. 16% e. insufficient information to compute #3. Capital City Manufacturing is considering a new equipment purchase that would replace some existing equipment. The old equipment has a Book Value (BV) of $400 thousand and RDP estimates that the equipment could be sold for ONLY $150 thousand. What is the After Tax Salvage Value (ATSV) of the old equipment that RDP should use in their capital budgeting analysis? Assume the tax rate = T= 35%. a. 0, since the sale of old equipment has nothing to do with analysis of new equipment being purchased b. 87.5 thousand c. 62.5 thousand d. -250 thousand e. 237.5 thousand #4. If you earn a 10% nominal return on an investment, are you really 10% more wealthy? a. No, because there may be inflation, which causes your real return to be less b. No, because if inflation = 0, then your real return is less c. Yes, because you really have 10% more dollars d. Yes, because inflation does NOT effect your real wealth e. Yes, because nominal returns are the returns widely published & quoted in the press