Cavanaugh Inc. has a beta of 1.2. Next year you project the market will earn 12% and the risk free rate will be 5%. If you buy Cavanaugh you project your return will be 13%. Thus you think:
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A. B. C. D.A
Rs = Rf + B(Rm - Rf)Rs = .05 + 1.2(.12-.05)Rs = .134 or 13.4%You project Cavanaugh will out perform the market.
To determine whether Cavanaugh Inc.'s projected return of 13% will outperform or underperform the market on a risk-adjusted basis, we need to compare it to the expected market return, considering the risk-free rate and the company's beta.
The risk-free rate represents the return an investor would earn by investing in a risk-free asset, such as a government bond. In this case, the risk-free rate is given as 5%.
Beta is a measure of a stock's volatility or sensitivity to market movements. A beta of 1 means the stock's returns move in line with the market. A beta greater than 1 indicates that the stock tends to be more volatile than the market, while a beta less than 1 suggests it is less volatile.
Given that Cavanaugh Inc. has a beta of 1.2, it is more volatile than the market.
Now, let's analyze the information provided:
To evaluate Cavanaugh's performance on a risk-adjusted basis, we can use the Capital Asset Pricing Model (CAPM). CAPM calculates the expected return of an investment based on its beta and the risk-free rate.
The formula for the expected return using CAPM is:
Expected Return = Risk-Free Rate + Beta × (Market Return - Risk-Free Rate)
Plugging in the values: Expected Return = 5% + 1.2 × (12% - 5%) Expected Return = 5% + 1.2 × 7% Expected Return = 5% + 8.4% Expected Return = 13.4%
Comparing the projected return of Cavanaugh Inc. (13%) to the expected return based on CAPM (13.4%), we can conclude that Cavanaugh is projected to underperform the market on a risk-adjusted basis. Therefore, the correct answer is:
A. Cavanaugh will underperform the market on a risk-adjusted basis.
This analysis considers the company's higher beta, which indicates greater volatility compared to the market, and the projected return falling slightly below the expected return calculated using CAPM.