Investments, tenth edition

 Figure 9.3 

The SML and a positive-alpha stock  

E(r) (%)

SML

6

14

15.6

1.2

1.0

17

Stock

M

α

β

 Yet another use of the CAPM is in utility rate-making cases.  

8

   In this case the issue is the 

rate of return that a regulated utility should be allowed to earn on its investment in plant 

and equipment. Suppose that the equityholders have invested $100 million in the firm 

and that the beta of the equity is .6. If the T-bill rate is 6% and the market risk premium 

is 8%, then the fair profits to the firm would be assessed as 6  1  .6  3  8  5  10.8% of the 

$100 million investment, or $10.8 million. The firm would be allowed to set prices at a 

level expected to generate these profits.  

 Example  9.1 

Using the CAPM 

  

8

 This application is becoming less common, as many states are in the process of deregulating their public utilities 

and allowing a far greater degree of free market pricing. Nevertheless, a considerable amount of rate setting still 

takes place. 

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6/21/13   3:39 PM

6/21/13   3:39 PM

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