Page 288 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Unit 11: Capital Market Theory

Calculate the weighted average of expected return and Beta factor of the portfolio. Notes
Solution:
Weighted Average of Expected Return of the Total Portfolio:
E(R ) = (14% × 0.5) + (16% × 0.2) + (12% × 0.3) = 7% + 3.2% + 3.6% = 13.8%
p
Weighted Average Market Sensitivity Index of the Total Portfolio:
p = (1.6 × 0.5) + (1.2 × 0.2) + (0.8 × 0.3) = 0.8 + 0.24 + 0.24 = 1.28
Risk-Return Trade-off

R m R t
R – r =
m i
m
Where,

R = Market rate of return
m
R = Risk free return
m
= Standard deviation of returns of market portfolio
m
r = Rate of return on individual investment
i
Example: The beta co-efficient of security ‘A’ is 1.6. The risk free rate of return is 12% and
the required rate of return is 18% on the market portfolio. If the dividend expected during the
coming year is 2.50 and the growth rate of dividend and earnings is 8%, at what price should
the security ‘A’ can be sold based on the CAPM.
Solution:
Expected Rate of Return is calculated by applying CAPM formula:
E(R) = R + (R – R )
i f i m f
= 12% + 1.6 (18% – 12%) = 12% + 9.6% = 21.6%
Price of security ‘A’ is calculated with the use of dividend growth model formula:

D
R = 1 + g
e
P
0
Where,
D = Expected dividend during the coming year
1
R = Expected rate of return on security ‘A’
e
g = Growth rate of dividend
P = Price of security ‘A’
0
D
R = 1 + g
P 0
e
2.50
0.216 = + 0.08
P 0

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