Question

Company A has a beta of 0.90, while Company B's beta is 1.20. The required return on the stock market is 11.00%, and the risk-free rate is 4.5%. What is the difference between A's and B's required rates of return? (Hint: First find the market risk premium, then find the required returns on the stocks.)

Answer 1

Answer:

The difference between A's and B's required rate of return is 1.95% with B's required rate of return being 1.95% higher than A's.

Explanation:

The required rate of return is the minimum return that investors require to invest in a stock. Using CAPM, we can calculate the required rate of return on a stock using the following formula,

r = rRF + Beta of Stock * (rM - rRF)

Where,

• rRF is the risk free rate
• rM is the expected return on market

For company A, r = 0.045 + 0.9 * (0.11 - 0.045)   =  0.1035 or 10.35%

For company B, r = 0.123 or 12.30%

The difference between A's and B's required rate of return is,

Difference = 12.30% - 10.35%  =  1.95% with B's required rate of return being 1.95% higher than A's.