Question

We Do Bankruptcies is a law firm that specializes in providing advice to firms in financial distress. It prospers in recessions when other firms are struggling. Consequently, its beta is negative, -0.1. a. If the interest rate on Treasury bills is 3% and the expected return on the market portfolio is 13%, what is the expected return on the shares of the law firm according to the CAPM? (Enter your answer as a whole percent.) Expected return % b. Suppose you invested 70% of your wealth in the market portfolio and the remainder of your wealth in the shares in the law firm. What would be the beta of your portfolio? (Do not round intermediate calculations. Round your answer to 2 decimal places.) Beta

Answer 1

Expected return on a security can be calculated using Capital Asset Pricing Model (CAPM) as follows: Ri = Rpg + (Rm – Rrp) • Ri = Expected return on security • Rre = Risk free rate of return = 3% O Treasury bills can be considered risk-free • B = Beta of the security = -0.1 • Rm = Expected return on market portfolio = 13% Expected return; Ri = 0.03 + -0.1(0.13 – 0.03) = 0.03 + -0.01 = 0.02 = 2%

Portfolio beta is the weighted average of the beta coefficients of all the individual securities in the portfolio. Bp = Wißi + W2B2 • W, = Weight of market potfolio in the portfolio = 70% · W2 = Weight of law firm's shares in the portfolio = (100% – 70%) = 30% • B1 = Beta of market = 1 (market portfolio has a beta of 1) • B2 = Beta of law firm's shares = -0.1 • Beta of portfolio Bp = (0.7 x 1) + (0.3 X-0.1) = 0.67