[Anonymous]

Hi, can anyone walk me through the following question?

Company A has a beta of 2.20 and required rate of 16% Company B has beta of 0.4. The risk-free rate is 5%. What is Company B’s required rate?

I understand that CAPM = risk-free rate + [beta x (required rate – risk-free rate)]

However, I’m stumped and I can’t seem to figure out how to calculate this problem.

Any help is appreciated, thank you!

[Anonymous]

Okay, so for this problem you have to actually work backwards. We understand that CAPM gives us the expected return on an investment. In your formula you need to replace “required rate” with “market rate”.

So we use the formula to algebraically solve for the market rate. I am not putting in % signs, but know that they exist. Company A's CAPM is given, so plug into the formula accordingly. M= market rate.

16= 5 + 2.20*(M-5)
11= 2.20*(M-5)
11=2.20M-11
22=2.20M
10=M

Market rate is 10%, now plug in company B's Beta:

5+.40(10-5)= 7

The CAPM predicts an expected return of 7% on Company B given their Beta. This is a longer question than I would expect you see on the exam, but if you understand the ins and outs of this problem, you will be well prepared for any CAPM problem on the exam.

Let me know if you have any questions or if this explanation makes sense.

[Author]

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