ECN357 Modern Finance Assignment 1 080175898

2. Given a risk free rate of return (Rf) of 8% and an expected return on the market

portfolio (Rm) of 16%, a firm considers a project that is expected to have a beta value

(β) of 1.4.

a. What is the required (expected) rate of return on the project? [10 marks]

The expected rate of return for a project is a calculated estimate of the return on an investment within the

Capital Asset Pricing Model (CAPM) framework. The expected rate of return can help investors decided

whether or not the risk they are taking is worthwhile. It is calculated using the risk free rate of return (R f),

the expected return on the market portfolio (Rm), and the beta value (β). The risk free rate of return

represents the rate of return on assets which carry no risk at all (Block and Hirt, 2008 pp. 309). Examples

of risk free assets include treasury bills and other government assured securities. The market portfolio is a

portfolio of all the stocks in the economy, where each is weighted by its market value. The beta value

represents the degree to which an asset, project or security is sensitive to volatility in the market as a

whole.

The pieces of information which have been given are:

Rf= 8% Rm=16% β= 1.4

To calculate the expected rate of return (E(Rp)), the following formula is used:

E ( R )=R f + β (R❑m−R f )

Substituting in the previous pieces of information, the expected rate of return on the project can be

calculated as:

E ( R )=8+1.4(16−8)

E ( R )=19.2

The required/expected rate of return for this project is 19.2%.

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ECN357 Modern Finance Assignment 1 080175898

b. What assumptions underlie the pricing of the project? [20 marks]

A number of assumptions are made when pricing projects within the CAPM framework. These

assumptions must all be met for accurate results to be achieved. This section of the assignment will

describe a number of different assumptions made when pricing this project, and explain the implications of

each assumption.

The CAPM model assumes that investors have homogeneous expectations of the market (Cass 1965 pp.

233). That is, it assumes that one typical investor’s views can be assumed, and that these views will be

replicated by all other investors in the market. This assumption has been noted as being somewhat

unrealistic by authors such as Levy and Levy (1996) who argue that discounting heterogeneous

expectations and expecting to find even approximately correct results with the CAPM model is

“dangerous” (pp. 65). This assumption, along with most of the following assumptions, is made to simplify

the model. If heterogeneous expectations were factored into the model (which is unlikely due to the

complications involved in acquiring such data), the resulting increase in complexity would perhaps lead to

lower levels of use.

A second major assumption of underlying the pricing of the project is a lack of transaction costs.

Transaction costs – the costs of trading assets – are often ignored in financial models, and their omission is

widely accepted. Elton et al (2010) state that, should transaction costs be included in the CAPM model,

“the return on any asset would be a function of whether or not the investor owned it before the decision

period” (pp. 283). This would add a great deal of complexity, as it would not be compatible with the basic

CAPM’s one-period nature. They go on to suggest that the degree to which this assumption affects results

of the model is usually negligible due to their small size in comparison to the value of assets.

The CAPM model also assumes an absence of personal income tax – that all investors pay the same rate of

income tax. This is not the case in most economies, which operate progressive tax systems whereby the

proportion of tax paid on income rises in accordance with amount of income. This assumption leads to

indifference from investors as to the breakdown of the total expected return of an asset (Bethke and Boyd,

1983)

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ECN357 Modern Finance Assignment 1 080175898

c. If the expected Internal Rate of Return (IRR) is 19% should the project be accepted? Explain. [10
marks]

Reject – 19.2>19

d. The firm is levered and has a debt-to-value ratio (D/(D+E)) of 0.4. Given a return to debt (R D)
of 15%, calculate the return to assets (RA). [20 marks]

D E
The formula used to calculate the return on assets includes the ratios of debt ( ¿ and equity ( ¿
D+ E D+ E
multiplied by their respective returns.

R❑ A = ( D+D E R )+( D+E E R )

The information supplied is:

D
=0.4 RD = 15%
D+ E

E
Using this information, it is possible to calculate :
D+ E
Since:

E D
+ =1
D+ E D+ E
Rearrange to find:

E D
=1−
D+ E D+ E

D
Substituting in the given value for :
D+ E

E
=1−0.4
D+ E

E
=0.6
D+ E

The return to equity was calculated in part a) of this assignment as 19.2% (WHY?!?!). Given this full set of
information, it is possible to calculate the return on assets, using the formula expressed above, as:

R❑ A =( 0.4 ×15 )+ ( 0.6× 19.2 )

R❑ A =6+11.52

R❑ A =17.52

The return on assets for the firm is 17.52%.

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ECN357 Modern Finance Assignment 1 080175898

e. Explain how the introduction of differential borrowing and lending rates influences the market portfolio
and the Capital Asset Pricing Model (CAPM). [40 marks]

Lectures 5-7

Bibliography

Block, S. A. and Hirt, G. A (2008). Foundations of Financial Management. London:

Cass, D. (1965). Optimum Growth in an Aggregative Model of Capital Accumulation. The

Levy, M. and Levy, H. (3). The Danger of Assuming Homogeneous