The Capital Asset Pricing Model

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You are considering an investment in Concordia Utilities and have some questions regarding the income generating abilities of the company.

Concordia Utilities has 4 plants in four states and they all operate as separate entities. All four plants are financed by Concordia and have no holdings of their own, but operate as if they were separate companies. You have gathered some information about the company’s plants as follows:

Table-1:

Plant

Beta Coefficient

% of Concordia’s Income

South Town

0.85

55%

North Town

0.90

20%

East Town

1.25

15%

West Town

1.60

10%

You have also gathered some information about the market and found that the risk-free rate of interest is 3% and that the company adds a market risk premium of 4% to all investments. The possible market returns and their probabilities are found in Table-2:

Table-2:

Probability

Return

0.15

8%

0.2

9%

0.5

10%

0.1

11%

0.05

12%

Questions:

  1. What is the Beta coefficient for Concordia?  Explain your answers.
  2. What is Concordia’s required rate of return on any new investments?  Explain your answers.
  3. What is the equation for the Security Market Line (SML)?  Show the equation and graph the equation on a graph.  Explain what the SML is telling you, and the implications for the firm.
  4. Suppose Concordia has the opportunity to purchase an additional plant.  The cost of the new plant will be $200 million and have a beta coefficient of 1.60.  If the new plant is expected to return 12%, should Concordia make the investment?  Explain your answers and justify your calculations.

Present your analysis of the assigned problems in Excel format. Enter non-numerical responses in the same worksheet using textboxes.

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