CAPM Question

“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?

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.

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.

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.

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.