# CAPM Tricky

Reding is using the sml approach to estimate the cost of equity associated with an expansion project of a national retailing firm mondanto. The common stock of Modanto has 10% more systematic risk than the market. Market risk premium = 7% RFR = 3.5% The project is similar to an online clother retailer than has a beta of 1.3 What is the cost of equity using SML and projection cost of equity using the pure play method? 11.20% ---------------------8.05% 7.35%-----------------------12.6% 11.2%-----------------------12.6% 7.35%-----------------------8.05%

I know the first part is 7.35 however I don’t know what pure play method is

nevermind I would say D

mambovipi, where did you get this question from? I am really interested to know because I did not bother memorizing the pure-play method (didn’t see it in LOS)

you dont need to know much about pure play method for this question. use CAPM, get cost of equity = 12.6 then for SML i dont know how to compute that. SML = security market line that has no unsystematic risk? correc.t so add 10% more to it i guess. I’d say c

I’d say C too 10% more risk than the market, that’s a beta of 1.1, that’s a 1.1*7+3.5=11.2 cost and then pure play use the beta of the second company, 1.3*7+3.5=12.6

I agree with map1 The beta of the market portfolio is always equal to 1 so after that do the maths. Pure play is when u use the beta of another company to calculate the required returns. But i am used to unlevering first then levering before using the beta of the company. But i am curious to know when it is appropriate to lever.

sorry got busy doing other q’s,…ANswer C

why are we not deducting the risk free rate in the calc? Explanation please

to lever and unlever you need the debt structure of both companies. you dont have that, so just use the given beta. also i noted that if pureplay is giving 12.6, then no chance sml can give 7.6 too much gap, so i picked C. but now i know how to compute using SML, thanks. map.

C for sure.

getterdone Wrote: ------------------------------------------------------- > why are we not deducting the risk free rate in the > calc? Explanation please because the premium already has done the deduction.

AHHHHH!!! need to read more carefully, thanks pepp! hows the studying coming buddy

------------------------------------------------------------------ 10% more risk than the market, that’s a beta of 1.1 ------------------------------------------------------------------ How does that work? Also this Q is out of book 7 schweser.

getterdone Wrote: ------------------------------------------------------- > AHHHHH!!! need to read more carefully, thanks > pepp! > > hows the studying coming buddy I am in panic mode, w/ 50% left to go. hehe. have started praying a bit lately.

I gotta say though, most of your answers are right to these questions. If you arent looking @ your texts to answer these you are doing pretty good!

Market Beta is assumed to be 1, so 10% more risky than the market implies a beta of 1.1…

Yes, that’s how I got beta of 1.1.

Getterdone, I was just saying they were going to trick us with the market risk premium yesterday, gggggrrrrr!