Chapter 12
What does the CAPM explain?
The relationship between expected return and systematic risk.
Why is after-tax cost of debt used in WACC?
Because interest payments are tax-deductible.
What is the main goal of portfolio diversification?
To reduce total risk by combining assets that don’t move perfectly together.
Which type of risk is not reduced by diversification?
Systematic (market) risk.
If a firm increases its leverage, what happens to the risk of its equity?
Equity becomes riskier; its beta increases.
Why do institutional investors often use index funds instead of picking individual stocks?
Because active managers rarely outperform the market after costs; index funds track the market cheaply and efficiently.
What does a Beta > 1 imply?
The stock is more volatile than the market, suggesting it is riskier. For example, a beta of 1.7 indicates that if the market goes up by 1%, the stock would tend to increase by 1.7%
Why should different projects use different discount rates instead of the same WACC?
Because projects can have different systematic risks and required returns.
What happens to the value of a bond when market interest rates rise?
Bond prices fall, since their fixed payments become less attractive compared to new bonds.
A stock has a beta of 1.3, the risk-free rate is 3 %, and the expected market return is 9 %. What is the expected return according to CAPM?
E(Ri) = Rf + βi × (E(Rm) − Rf)
E(R) = 3 % + 1.3 × (9 % − 3 %) = 10.8 %.
A company finances itself with 70 % equity and 30 % debt. If rE = 12 %, rD = 5 %, and the tax rate = 25 %, what is its WACC?
WACC = (E / (E + D)) * rE + (D / (E + D)) * rD * (1 - Tc)
WACC = 0.7 × 12 % + 0.3 × 5 % × (1 − 0.25) = 8.85 %.
Why do small-cap stocks generally offer higher expected returns than large-cap stocks?
Because they are riskier and less liquid, so investors demand a higher risk premium for holding them.
If the market risk premium is 5 % and a stock’s beta decreases from 1.2 to 0.8, by how much does its expected return change?
ΔE(R)=(β1−β2)×(E(Rm)−Rf)
ΔE(R) = (1.2 − 0.8) × 5 % = 2 %
It falls by 2 percentage points.
A firm’s equity beta is 1.8, its debt beta 0.2, and its capital structure is 60 % equity / 40 % debt.
What is the firm’s unlevered beta?
βU = (0.6 × 1.8) + (0.4 × 0.2) = 1.16.
So the firm’s asset (unlevered) beta is 1.16.
In global investing, why does capital often flow from developed to emerging markets despite higher risk?
Because emerging markets offer higher expected returns to compensate for higher political, economic, and currency risk, reflecting the global risk–return trade-off.