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Introduction to Capital Market Line

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What is the capital market line? Who uses it? Would you use it? Who discovered it? How does the capital market line relate to the security market line?

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Capital market line (CML) is the tangent line drawn from the point of the risk-free asset to the risky assets (i.e. market portfolio lies in the optimal risk-return point, with risk being defined as the portfolio's standard deviation). In practice, the U.S. government Treasuries is considered as the risk-free assets while broad equity market index such as S&P 500 is a common proxy for risky assets .

The CML is a fundamental concept in financial studies, and is widely used ...

Solution Summary

Introducing the Capital Market Line, with an explanation of its function, relation to the Modern Portfolio Theory and CAPM.

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Analyze a capital project that the system's staff is proposing

Ms. Sharpe, your supervisor, has asked you to analyze a capital project that the system's staff is proposing. It is an exciting project, and given that it is your second week with the company, you want to do an excellent job, especially in presenting the results.

Based upon the information you have received from Ms. Sharpe, and based upon discussion with the IT staff, you have assembled the following information.

The computer to run the new system will cost $300,000 and is expected to have a useful life of five years. Given that there is an active "used" market for these computers the salvage value is projected to be $100,000. It will take $250,000 in programmer support to build the system and the tax manager told you that this expense would need to be capitalized (added to the cost of the computer to get it running) and depreciated along with the computer using the straight-line method. The time to build the system is projected to be twelve months.

The marketing staff is excited to have the system's capabilities and have estimated that they could save about $95,000 per year in administrative expenses over the next five years with the system. They also suggested that sales of the product line that the system will support will increase by three percent per year over the systems life and sales are currently $4,500,000. Other marketing and advertising and expenses are not expected to changes. The product line is reasonable profitable and has a gross profit of 65%.

In your introduction to the company and the finance staff, you recall that the hurdle rate used in capital projects was 12% for projects that the company believers are routine. This project seems to qualify as "routine" based upon Ms. Sharpe's assessment. You also recall that the company's tax rate is 40%.

The only issue that has been raised in discussions with the marketing staff is the likelihood of the sales increases. Some members thought that three percent sales increase was too high based upon past experience. This group thought that one to two percent would be more likely.

What is your recommendation to Ms. Sharpe and why?

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