2414-FINANCIAL MANAGEMENT-2223_S1

Financial
Management
Week #11

JORGE FREIRE CARDOSO

PAULA ANTÃO
FINANCIAL MANAGEMENT | CAPM

CAPM – Capital Market line

Slide #2
 if i can diversify caus ei wanna tangency i dont care about is risk of assets but
FINANCIAL MANAGEMENT | CAPM
the one that i cannot diversify because the assets will be on the SML and if i
create one factor model tries to tell me whre my asset will be
assets i will be risk-free and then i create a line about the xpected return and

CAPM – Security Market line

beta (risk)
if market is in
equilibrium has
the most
effiency (?)
stocks have higher
risk because things
goes wrong stockes
in recession go down
more than the market
for beta stocks they
wanna higher return

Slide #3
FINANCIAL MANAGEMENT | CAPM

formula od a - (E=A+B
B (not in the formula sheet) learn it!--> if its an efficient portofolio

Exercise 1 the return of C is risk-free * expected return on the market

Consider the following information. The CAPM assumptions are valid.

Portfolios E(r) % St. Dev. % Beta

Market 5 6
A 1 0
B 7.5 0.5
C 6 portofolio B expected return= risk free + beta b
+4%
a. Compute the beta of portfolio C. Justify.
b. Compute the standard deviation of portfolio C knowing it is an efficient portfolio.
c. What is the expected return of portfolio B? Is portfolio B an efficient portfolio?
d. Please explain if two risky assets can have the same total risk (measured by the standard deviation) and different expected
return (maximum 5 lines).

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FINANCIAL MANAGEMENT | CAPM

Exercise 2
Firm ONE is not listed and has never computed a beta of its own stock. However, there is information on other companies
operating in the same industry
Average values for firms in the same industry
Cost of debt 3%
Equity beta 1.2
Leverage = D/E 0.25

Assume that the risk free interest rate is 2% and the market risk premium is 5%. Companies pay 30% income tax rate.
a. Firm ONE would like to expand its activities in the same industry but being 100% financed with equity. What is the
discount rate that Firm ONE should use to evaluate such projects?
b. Suppose that Firm ONE would like to be partially financed with debt (D/E = 10%) with a cost of 2.95%. In this case,
compute the cost of equity capital and the weighted average cost of capital
D(1 − t) E D(1 − t)
Hint: βU = βD + βL ⇔ βL = β𝑈 + β𝑈 − β𝐷
E + D(1 − t) E + D(1 − t) E

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FINANCIAL MANAGEMENT | CAPM

Exercise 3
Firm Xelse is a levered firm financed 80% with equity and 20% with debt. The beta of equity is 1.2 and the cost of debt is 3%. It is
also known that the risk free rate is 2% and the market risk premium is 5%. There are no taxes.
a. Compute the required return on equity.
b. Compute the weighted average cost of capital.
c. Compute the cost of capital of the unlevered firm.

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FINANCIAL MANAGEMENT | CAPM

Exercise 4
Consider the following information on three assets: A, B and the market portfolio. The CAPM assumptions are valid and
there is a risk free asset.

a. What is the beta of A? What is the beta of B? No calculations needed, just provide a brief explanation.
b. How would you form the best portfolio with 12% standard deviation? What is the expected return of this portfolio?
c. Recently you observed that another portfolio (C) has a beta of 1.2 and an expected return of 11%. Is security C
correctly priced according to the CAPM?

Slide #7