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.
While Value Line, Bloomberg, and other financial services provide estimates of beta, they are often very different. In this exercise, we are going to have you eyeball a value for beta. Go to finance.yahoo.com .
3. Enter Oracle (ORCL) in the "Enter System" box and click "Go."
4. Along the left margin, click on "Basic Chart."
5. Then on the "Range" line, click on "2y."
6. Then on the "Compare" line, select S&P and click "Compare."
7. Eyeball the relative volatility of ORCL to the Standard and Poor Index (GSPC) and estimate a beta (such as 1.1 or 1.3) based on the 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. McDonald's (MCD)
b. Bank of America (BAC)
c. Coca-Cola (KO)
10. What conclusion can you draw between the relationship of beta (bi), a risk measure, and the required rate of return (Ki)?
This solution calculates required rate of return for Oracle, McDonald's, Bank of America, and Coca Cola. This solution discusses Beta and the relationship between Beta and required rate of return in 143 words.