Question

Suppose CAPM holds, and the beta of the equity of your company is 2.33. The expected market risk premium (the difference between the expected market return and the risk-free rate) is 6.00% and the risk-free rate is 3.25%. Suppose the debt-to-equity ratio of your company is 35% and the market believes that the beta of your debt is 0.30. What is return on assets of your business? (Allow two decimals in the percentage but do not enter the % sign.)

Answer 1

14%

Step-by-step explanation:

Capital asset pricing model measure the expected return on an asset or investment. it is used to make decision for addition of specific investment in a well diversified portfolio.

Formula for CAPM

Expected return = Risk free rate + beta ( market risk premium )

First we need asset beta to calculate the rate of return.

If Debt to equity ratio is 35% then the equity is 100%.

Debt to equity ratio = 35% = 0.35

Beta(asset) = (2.33 x 1/1.35) + ( 0.3 x 0.35/1.35)

Beta(asset) = 1.73 + 0.08 = 1.81 = 1.8

Now place values in the CAPM formula

Required Rate of return = 3.25% + 1.8 x (6%) = 14.05%

Answer 2

The Return On Assets of the business is 0.1956, approximately 0.20 to two decimal places and without entering the percentage sign.

With the percentage sign, it would be 19.56% approximately 20%

Step-by-step explanation:

Using the CAPM (Capital Asset Pricing Model) which explains the relationship between expected return on assets and systematic risk,

The formula for Expected Return On Assets is:

ERA = RFR + BOA (MRP)

where ERA = expected return on assets

RFR = risk-free rate

BOA = beta of the asset

MRP = market risk premium

First, we need to get the BOA

In the absence of tax rate, the BOA is = (BOE × DTER) ÷ BOD

where BOE = beta of equity

DTER = debt-equity ratio or debt to equity ratio

BOD = beta of debt

BOA = (2.33 × 0.35) ÷ 0.3

= 0.8155 ÷ 0.3 = 2.7183

Now, ERA = 3.25% + 2.7183 (6%)

ERA = 0.0325 + 2.7183 (0.06)

ERA = 0.0325 + 0.1631

ERA = 0.1956 approximately 0.20 to two decimal places.