1. Based on historical market performance, what can we conclude about the relationship between return and risk?
2. Explain in words what beta is and why it is an important tool of security valuation.
3. According to the CAPM, the expected return on a risky asset depends on three components. Describe each component, and explain its role in determining expected return.
4. In a multifactor model, explain what a factor represents and the role that beta plays in relation to factors. How do factors and betas affect the actual return?
5. World Corporation has traditionally employed a firm-wide discount rate for capital budgeting purposes. However, its two divisions, publishing and entertainment, have different degrees of risk given by _P = 1.1, _E = 1.8, while the beta for the overall firm is 1.3. The publishing division has proposed three projects with the following internal rates of return: P₁ = 13.2 percent; P₂ = 12.4 percent; and P₃ = 9.8 percent. The entertainment division has presented their three projects: E₁ = 16.4 percent; E₂ = 17.8 percent; and E₃ = 14.7 percent. The risk-free rate is 4 percent and the market risk premium is 8 percent. Identify which projects will be accepted if the firm applies its overall beta to all projects. Then identify which projects will be accepted if the division betas are properly applied.