Question

Mini-Case Risk, Return, and the Capital Asset Pricing Model On your first day as an intem at Tri-Star Management Incor 5% over the next year. Also, information from an investment porated the CEO asks you to analyze the following infor- advising service lists the current beta for Tech.com as 1.68 mation pertaining to two common stock investments. Tech. and for Sam's Grocery as 0.52. You are provided a series of com Incorporated and Sam's Grocery Corporation. You are questions to guide your analysis, told that a one-year Treasury Bill will have a rate of retum of Economy Recession Average Expansion Boom Probability 30% 20% 35% 15% Tech.com -20% 15% 30% 50% Estimated Rate of Return Sam's Grocery 5% 6% 8% 10% S&P 500 -4% 11% 17% 27% Continued

Answer 1

Expected return on Sam’s grocery= 0.3* 5% + 0.2*6% + 0.35*8% + 0.15* 10% = 7%

Expected return on Tech.com = 0.3*(-20%) + 0.2*15% + 0.35*30% + 0.15*50% = 15%

Expected return on the market = 0.3 * -4 + 0.2*11% + 0.35*17% + 0.15* 27% = 11%

As Expected returns on TEch.com > Market returns , it is providing higher risk adjusted return for a stock based investment. Sam’s grocery ends up providing lower returns than even a passively traded market. The cost of active investing is high and thus would be adjusted in the pricing.

Hence Tech.com is chosen over Sam’s grocery.