Equities,Quant market, return, interest, expected

hanvinh

When you calculate CAPM, do you use:

market return - nominal interest rate

OR

market return - real risk-free interest rate.

-------------------------------

When you calculate NPV, and you've given the risk-free interest, expected inflation rate, and market risk premium & beta, to calculate the cost, do you use:

Risk-Free + Expected Inflation + Market Risk Premium

OR

Risk-Free + Market Risk Premium

evolsteevol

A project has the following expected cash flows:

Time 0 = -125,000
Time 1 = 100,000
Time 2 = 200,000

If the risk free interest rate is 4%, expected inflation is 3%, the market risk premium is 8% and the beta for the project is 1%, the investment's net present value (NPV) is closest to:

A) $113,000
B) $124,000
C) $139,000

If you add the Risk-Free + Expected Inflation to get the nominal rate of 15.12, before calculating using CAPM, you will get I of 12.15% and you get answer A.

BUT,

If you don't add the Risk-Free to Expected Inflation and just use the 4% risk-free rate, and you calculate the cost, you will get 12% and get answer B.

Why the difference?

kd26gioi

If the risk free interest rate is 4%, <-- i take that to mean its the nominal rate, so don't adjust for inflation.

I would say B

LokiDog2

You should be using 15.12, you have to use nominal risk free rate and not just risk free rate. Clearly mentioned in Schweser.

ajpheif16

guys, i've been sleeping for one hour so...

my opinion:

- real RFR must be transformed int nominal RFR, (1.04)*(1.03)-1 = 7.12%
- expected market return of 12%
- beta 1

ke= 12%

kasinkei

acer Wrote:
-------------------------------------------------------
> You should be using 15.12, you have to use nominal
> risk free rate and not just risk free rate.
> Clearly mentioned in Schweser.

If a rate is not clearly labeled as REAL, you can assume its a nominal rate. the inflation rate is there to confuse you. the 3% inflation is already included in the 4% (If we assume the 4% is nominal).

We all know to use the nominal rate...the real question is, if a RFR is not clearly labeled as REAL or NOMINAL, which should we assume it is? Schweser says assume its nominal unless CLEARLY stated as REAL.

Damil - whats the answer? the wording is unclear on this one



Edited 1 time(s). Last edit at Friday, June 5, 2009 at 10:42AM by june2009.

Wasteoftime

If RFR is given and it's not mentioned whether it's real or nominal, is it not safe to assume that it's a nominal rate? Even if the expected inflation rate is mentioned in the question..(like Damil's question up there)

Ionutzakis

P 216 Schweser book 4.

If a RFR is given with no qualifiers, it IS SAFE to assume its nominal.

pacmandefense

I think I've seen this question before. As june2009 mentioned, who needs a more creative handle btw, if it is labeled as the risk free rate I believe you can safely assume that that rate is in fact the nominal risk free rate. I believe that will solve the problem correctly.

joemoran

I thought that sounded familiar..