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In this web exercise we will show how to determine the required rate of return for a stock using the capital asset pricing model.
1. The formula for the capital asset pricing model is:
Ki=Rf + bi(Km-Rf)Ki is the required rate of return that we are solving for ; Rf is the risk-free rate; and we shall assume it is 4.6 percent; bi is the systematic risk of a stock that we will estimate; (Km-Rf) is the equity risk premium or the amount the market is assumed to earn over the risk-free rate in the long-term. We will use 6.4 percent in this example.
2. Now we are in a position to estimate the beta for a company and compute Ki, the required rate of return. Use finance.yahoo.com to find values of beta.
3.Enter Microsoft (MSFT) in the "Enter System" bock and click "Go"4. Along the left margin, click on "Basic Chart"5.Then on "Range" line, click on "5y max".6. Then on the "Compare" line, select S&P and click "Compare".7.Eyeball the relative volatility of MSFT to the Standard and Poor Index (SPX) and estimate a beta (such as 1.1 or 1.3) based on relative volatility of the stock versus the index.8.Use this beta and the previously presented information on Rf and (Km-Rf) to compute Ki.9. Follow this procedure for:a. Oracle (ORCL)b. IBM (IBM)c. Philip Morris (Mo)10. What conclusion can you draw between the relationship of beta (bi), a risk measure and the required rate of return (Ki)?
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