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    Decision Models - CAPM and Residual Earnings

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    MD&A includes the manager's forecasts for the firm's future. Specially, the forecasts can help to estimate future cash flows or future earnings that can be generated by the firm. Which decision model can most benefit from the forecasts?

    A. CAPM
    B. Residual Earnings Model
    C. Equally Beneficial.

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    Solution Preview

    Please refer to the attached file for the response.


    According to Keown et al. (2002), CAPM is an equation that equates the expected rate of return on a stock to the risk-free rate plus a risk premium for the stock's systematic risk. These authors further noted that the CAPM provides an intuitive approach in determining the return that an investor should require on all investments, given the asset's systematic or market risk.

    This concept is confirmed by an online source when it noted that, "The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free ...

    Solution Summary

    The solution uses decision models that calculate CAPM and residual earnings.