Question

If the return on the risk-free security is 3% and the return on Digital Computer Incorporated is expected to be 18% (with beta of 1.5), what must be the return on the market, according to CAPM

Answer 1

According to the Capital Asset Pricing Model (CAPM), the expected return on the market is calculated to be 13%, given the provided information of a risk-free rate of 3%, an expected return of 18% for Digital Computer Incorporated, and a beta of 1.5.

Step-by-step explanation:

To determine the expected return on the market using the Capital Asset Pricing Model (CAPM), we use the formula:

Ri = Rf + βi(Rm - Rf)

Where Ri is the expected return on the investment, Rf is the risk-free rate, βi is the beta of the investment, and Rm is the expected market return.

Given that the risk-free rate (Rf) is 3%, the expected return on Digital Computer Incorporated (Ri) is 18%, and the beta (βi) is 1.5, we can rearrange the formula to solve for the market return (Rm):

Rm = (Ri - Rf)/βi + Rf

Rm = (18% - 3%)/1.5 + 3%

Rm = 15%/1.5 + 3%

Rm = 10% + 3%

Rm = 13%

According to CAPM, the expected return on the market should be 13%.