Introduction to Corporate Finance

7: Risk, Return and the Capital Asset Pricing Model

P7-2 The table below shows the historical difference in returns between US shares and US Treasury bills
and the difference between US shares and US Treasury bonds at 10-year intervals.

Years Shares vs. Treasury bonds Shares vs. Treasury bills

1964–73 3.7% 8.3%

1974–83 0.2% 8.6%

1984–93 7.5% 5.4%

1994–2003 4.8% 2.1%

a At the end of 1973, the yield on Treasury bonds was 6.6% and the yield on Treasury bills was

7.2%. Using these figures and the historical data from 1964–73, construct two estimates of the

expected return on equities as of December 1973.

b At the end of 1983, the yield on Treasury bonds was 6.6% and the yield on Treasury bills was

7.2%. Using these figures and the historical data from 1974–83, construct two estimates of the

expected return on equities as of December 1983.

c At the end of 1993, the yield on Treasury bonds was 6.6% and the yield on Treasury bills was

2.8%. Using these figures and the historical data from 1984–93, construct two estimates of the

expected return on equities as of December 1993.

d At the end of 2003, the yield on Treasury bonds was 5.0% and the yield on Treasury bills was

1.0%. Using these figures and the historical data from 1994–2003, construct two estimates of the

expected return on equities as of December 2003.

e What lessons do you learn from this exercise? How much do your estimates of the expected

return on equities vary over time, and why do they vary?

P7-3 Use the information below to estimate the expected return on the shares of Bieber Corporation.

■ Long-run average share return = 12%

■ Long-run average Treasury note return = 3%

■ Current Treasury note return = 1%.

P7-4 Calculate the expected return, variance and standard deviation for the shares in the table below.

Product demand Probability Share returns in each scenario

Share 1 Share 2 Share 3

High 20% 30% 20% 15%

Medium 60% 12% 14% 10%

Low 20% –10% –5% –2%

P7-5 Calculate the expected return, variance and standard deviation for the shares listed below.

State of the economy Probability Share returns in each state

Share A Share B Share C

Recession 25% –20% –10% –5%

Normal growth 55% 18% 13% 10%

Boom 20% 40% 28% 20%