Question

Kate just received $5,000 as a graduation gift and she in considering investing the gift in shares of Mayo Inc. Kate has gathered the following information about Mayo Inc.:

Current Share Price: $55

Expected price at the end of the year: $61

Return on the market portfolio: 8%

Estimated beta: 2.9

Expected dividend at the end of the year: $4

Return on Government of Canada T-Bills: 3%

Should Kate purchase shares in Mayo Inc.?

Show your work and explain.

Answer 1

Calculate expected return based on expected price and dividend:

Expected return = (Expected dividend + Expected Price - Current price)/Current Price

Expected return = (4 + 61 - 55)/55

Expected return = 18.18%

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Expected return based on CAPM equation:

Return on equity = Risk free rate + Estimated beta x (Market return - Risk free rate)

Return on equity = 3% + 2.9 x (8% - 3%)

Return on equity = 17.50%

If CAPM equation holds, the return on equity would be 17.50% not 18.18%. Hence, Kate should not purchase shares based on expected returns if CAPM holds.

Note: If the 17.50% return is sufficient for Kate then only she can chose to invest but based on expected return she should not.