CAPM vs Build Up Approach
Date: October 7, 2008 10:59PM
It appears to me that they both are a form of calculating the investors required rate of return.
My question is, how do you know which one to use? Here are 2 questions that i am referring to:
1) John is estimating the required rate of return to use in valuing the stock of XYZ company. John has the following estimates about the stock and interest rates:
Flintrock stock beta = 0.8
Real risk-free rate = 2%
Expected inflation rate = 3%
Flintrock's Equity Premium = 6%
Based on this information (and using the buildup approach), the discount rate is:
B is the answer
My question is more, how would you calculate it if they didnt tell you to use the buildup approach, or would they have to?
2) Which of the following least accurately describes a component of an investor's required rate of return?
b) the real risk free rate
c) systematic risk
d) risk premium
the answer is C.
my question again, how did you know if they were referring to capm or buildup, b/c i thought systematic risk (beta) is a component of capm.
Date: October 8, 2008 03:03AM
the answers to quest 2 signal to you that it is a CAPM based qualitative question...
Date: October 8, 2008 05:21AM
How did you get 11.36% in question 1?
Date: October 8, 2008 10:05AM
> With the buildup approach:
> (1+Real Risk-Free Rate) * (1+Expected Inflation
> Rate) * (1+Flintrock's Equity Premium) - 1 =
> (1+2%) * (1+3%) * (1+6%) - 1 = 11.36%
> This question is obviously trying to confuse you.
> By giving you Flintrock's beta, it is
> "encouraging" you to mix the CAPM and the build-up
> approach. That's why it is very important to read
> the question carefully; there might be several
> possible models, and the question might give you
> the data to use all of these models, but you will
> only score points if you use the right model.
i agree French. So both methods do calculate an investors reuired rate of return.
It also seems that which method to use depends on the answer choices as well as the question information. Im guessing they wouldnt give you the ability to calculate Rce using both methods, without telling you which to use.
Date: October 8, 2008 10:10AM
> It also seems that which method to use depends on
> the answer choices as well as the question
> information. Im guessing they wouldnt give you the
> ability to calculate Rce using both methods,
> without telling you which to use.
The question clearly stated: "Based on this information (and using the buildup approach), the discount rate is". Therefore, you should use the buildup approach.
Date: October 8, 2008 10:29PM
I haven't gotten to the buildup approach yet, but...that seems idiotic. I took 7 college courses in finance, and have read more than a handful of books on valuation and investing, and have yet to hear of that formula for calculating a required rate of return. I guess I take back my statement that it's idiotic, but rather, I say that it does not serve any use in the real world.
Date: October 8, 2008 10:38PM
build up approach????