CAPM Question

[blackscholesvol]

“Using the CAPM, the company’s cost of equity = 3.50% + 1.80(5.25%) = 12.95%. Comparing this result with the fund manager’s required rate of return of 13.60%, the fund manager should not invest in the stock.”
If CAPM specifies that the cost of equity is 12.95%, this is the minimum required return for investors. Since the manager requires 13.60%, why wouldn’t he NOT want to invest?
When would he want to invest it in? If his required return is equal or less than the investors required return?

 

[MrSmart]

His required return is 13.6%, the cost of equity using the CAPM assumptions is calculated at 12.95%.
If we assume the CAPM model holds, then the fund manager requires a higher return for his investment than this stock. Required return means minimum expected return.

 

[cpk123]

If you invest in the stock -> you can only earn 12.95% - but you require 13.6%, so a higher returning stock is required.
If however the CAPM return had been greater than the 13.6% at the same level of risk - you could have invested in the stock.
If the return for a given level of risk is ABOVE the rf + beta (rm -rf) line - you accept investment.

 

[MrSmart]

cpk123 wrote:
If however the CAPM return had been greater than the 13.6% at the same level of risk - you could have invested in the stock.
If the return for a given level of risk is ABOVE the rf + beta (rm -rf) line - you accept investment.

While staying on topic of the question, the fund manager requires at least 13.6% return, irregardless of risk levels.
If the return of a stock was above the SML but still less than 13.60%, he would have rejected the investment.

 

[S2000magician]

MrSmart wrote:

cpk123 wrote:If however the CAPM return had been greater than the 13.6% at the same level of risk - you could have invested in the stock.
If the return for a given level of risk is ABOVE the rf + beta (rm -rf) line - you accept investment.

While staying on topic of the question, the fund manager requires at least 13.6% return, irregardless of risk levels.

I don’t see that it says that it’s irrespective of risk levels. All it says is that he requires a 13.6% return. We don’t know if that’s only for this stock, or if it’s for other investments as well. I see no justification to generalize that requirement.

 

[MrSmart]

S2000magician wrote:

MrSmart wrote:

cpk123 wrote:If however the CAPM return had been greater than the 13.6% at the same level of risk - you could have invested in the stock.
If the return for a given level of risk is ABOVE the rf + beta (rm -rf) line - you accept investment.

While staying on topic of the question, the fund manager requires at least 13.6% return, irregardless of risk levels.

I don’t see that it says that it’s irrespective of risk levels. All it says is that he requires a 13.6% return. We don’t know if that’s only for this stock, or if it’s for other investments as well. I see no justification to generalize that requirement.

From the context, it’s evident that it’s for a marginal investment with that required return. If a risk free investment produced 13.5% return, he would not pick the investment for his portfolio. As per his guidelines.