1. Why do financial mangers have difficulty applying CAPM in decision making? What benefits does CAPM provide them?
2. Explain why assets must be evaluated in a portfolio context© BrainMass Inc. brainmass.com October 24, 2018, 7:59 pm ad1c9bdddf
Why do financial mangers have difficulty applying CAPM in decision making?
The model  does not appear to adequately explain the variation in stock returns. Empirical studies show that low beta stocks may offer higher returns than the model would predict. Some data to this effect was presented as early as a 1969 conference in Buffalo, New York in a paper by Fischer Black, Michael Jensen, and Myron Scholes. Either that fact is itself rational (which saves the efficient markets hypothesis but makes CAPM wrong), or it is irrational (which saves CAPM, but makes EMH wrong - indeed, this possibility makes volatility arbitrage a strategy for reliably beating the market).
The model assumes that investors demand higher returns in exchange for higher risk. It does not allow for investors who will accept lower returns for higher risk. Casino gamblers clearly pay for risk, and it is possible that ...
Decision Trees and portfolio theory
A company has developed two types of synthetic fuel. However it has not developed efficient manufacturing processes for either of them. It has has the option to develop the manufacturing process for both, either or none of them.
They estimate that if they try to develop a process for fuel A then their probability of success is 0.46. If they do succeed then they expect that they could sell the process to another company for $43,600. Alternatively they could manufacture the fuel themselves, in which case they estimate that if the market is strong then they will achieve a revenue stream with a net present value (NPV) of $68,200, or if the market is week a NPV of $28,100. They estimate the probability of the market being strong for fuel A as being 0.45. Attempting to develop the process is expected to cost $38,800. This amount needs to be deducted from all of the above returns to determine the profit for each situation ... Continued in word file
A particular security gives an average return of $14.65 per year and has a beta of 0.5. The return on the market portfolio is 0.07 and the risk free rate is 0.05. What should be the value of this security? What would your answer for the value of the security be if you were given the additional information that the probability of default is 0.04?