Question

Alfa Ltd currently under consideration is an investment with a beta, b, of 1.5. Currently, the risk-free rate of return R_F, is 3%, and the return on the market portfolio of assets r_m is 10%. You believe this investment will earn an annual rate of return of 11%.

1. If the return on the market portfolio were to increase by 10%, what would you expect to happen to the investment’s return? What if the market return were to decline by 10%.
2. Use the capital asset pricing model (CAPM) to find the required return on this investment.
3. Based on your calculation in part b, would you recommend this investment? Why or why not?

Answer 1

Required rate of Return under CAPM = Rf + beta(Rm-Rf)

Current Rate of Return under CAPM = 3% + 1.5(10%-3%) = 13.5%

If Return on market portfolio Increases by 10%, then

Rate of Return on Investment = 3% + 1.5(20% - 3%) = 28.5%

If Return on market portfolio reduces by 10%, then

Rate of Return on Investment = 3% + 1.5(0 - 3%) = 3%

This Investment would be recommended only in the positive market return but not in negative market portfolio return. As the current rate of return under CAPM is more than the desired return. It is a good investment