Capm Case

You are the financial manager of a company which is deciding on a new investment. The expected return on the investment is 8%. The return on the risk-free asset is 5% and the beta value of the investment is 0.5 Using the Capital Asset Pricing Model (CAPM) describe the values of the market portfolio for which this project would be one which should be undertaken. How would your answer change if the return on the beta value of the investment rose to 1? How can this change be explained in terms of the behaviour of investors? Briefly describe how well the CAPM is supported by empirical evidence. [20 marks]

Guideline Answer

Using the model, we need a required return of 8% or less. Plugging this into the equation 8% = 5% + 0.5(rm - 5%) and so rm must be less than 11%. If the beta value rose to 1 using the same equation rm would have to be less than 8%. The explanation for this is that in the first case our project is less risky than the market so investors will accept a return which is less than that on the market portfolio (provided it is not too much less) while in the second case the risk on our project is the same as that for the market portfolio (beta of one) and so investors will only accept the project if it is no more risky than the market portfolio. The CAPM was quite well supported by empirical evidence in early tests (especially if we use the version with a zero beta asset rather than a risk free asset). But recent studies have raised two key issues: (a) can we really test the CAPM given the difficulties of defining the market portfolio? (b) does a three-factor model of the kind proposed by Fama and French, which uses size and book-to-market values as well as beta, perform better than the CAPM?