CAPM

Ri RF i (RM RF )

This number provides a measure of how much systematic risk a firm's equity has when compared
to the market. Unlevering the beta removes any beneficial effects gained by adding debt to the
firm's capital structure. Comparing companies' unlevered betas gives an investor a better idea of
how much risk they will be taking on when purchasing a firms' stock

The formula to calculate a company's unlevered beta is:

Problems MPT CAPM

1. In December 1995, Boise Cascade's stock had a beta of 0.95. The treasury bill rate at the
time was 5.8%, and the treasury bond rate was 6.4%. The historical risk premium of the
Standard&Poor index is 5.5%. The firm had debt outstanding of $ 1.7 billion and a market
value of equity of $ 1.5 billion; the corporate marginal tax rate was 36%.
1

a. Estimate the expected return on the stock for a short term investor in the company.
b. Estimate the expected return on the stock for a long term investor in the company.
c. Estimate the cost of equity for the company.
use the historical premium of 8.5% to estimate expected returns short term
2. Boise Cascade also had debt outstanding of $ 1.7 billion and a market value of equity of $
1.5 billion; the corporate marginal tax rate was 36%. The historical risk premium of the
Standard&Poor index is 5.5%.
a. Assuming that the current beta of 0.95 for the stock is a reasonable one, estimate the
unlevered beta for the company.
b. How much of the risk in the company can be attributed to business risk and how
much to financial leverage risk?
3. Biogen Inc., as biotechnology firm, had a beta of 1.70 in 1995. It had no debt outstanding at
the end of that year.
a. Estimate the cost of equity for Biogen, if the treasury bond rate is 6.4% and the
expected yield of S&P index is 12%.
b. What effect will an increase in long term bond rates to 7.5% have on Biogen's cost
of equity?
c. How much of Biogen's risk can be attributed to business risk?
4. Genting Berhad is a Malaysian conglomerate, with holding in plantations and tourist
resorts. The beta estimated for the firm, relative to the Malaysian stock exchange, is 1.15, and
the long term government borrowing rate in Malaysia is 11.5%. The Malaysian Stock Market
risk premium is expected to 7,5%.
a. Estimate the expected return on the stock.
b. If you were an international investor, what concerns, if any, would you have about
using the beta estimated relative to the Malaysian Index? If you do, how would you
modify the beta?

5 Safecorp, which owns and operates grocery stores across the United States, currently has
$50 million in debt and $100 million in equity outstanding. Its stock has a beta of 1.2. It is
planning a leveraged buyout , where it will increase its debt/equity ratio of 8. If the tax rate is
40%, what will the beta of the equity in the firm be after the LBO?
Problem 6

Suppose you estimate that stock A has a volatility of 32% and a beta of 1.42, whereas
stock B has a volatility of 68% and a beta of 0.75.
(a) Which stock has more total risk?
(b) Which stock has more market risk?
(c) Suppose the risk-free rate is 2% and you estimate the market's expected return as
10%. Which security has a higher cost of equity capital?

Problem7

The following table lists possible rates of return on

Compton Technology's stock and debt, and on the
market portfolio. The probability of each state is also
listed.

State
1
2
3
4

Probability
0.1
0.3
0.4
0.2

Return on
Equity (%)
3%
8%
20%
15%

Return on
Debt (%)
8%
8%
10%
10%

Return on
the
Market (%)
5%
10%
15%
20%

a. What is the beta of Compton Technology debt?

b. What is the beta of Compton Technology stock?
c. If the debt-to-equity ratio of Compton Technology is .5, what is the asset beta of Compton Technology?

Problem 8
There are four stocks a,b,c,and d each of them is available at Rs 110 currently in the market.
3

Find out which of the following securities are under/overpriced use alpha values for your conclusions
stock
a
b
c
d

Problem 9

actual
beta
risk free rate market return
10
0.5
5
15
2.5
5
12
2
5
20
1.75
5

10
10
10
10