Question

Suppose that the risk-free rate is 5% and that the market risk premium is 7%. What is the required return on (1) the market, (2) a stock with a beta of 1.0, and (3) a stock with a beta of 1.7? Ehrhardt, Michael C.. Corporate Finance: A Focused Approach (p. 286). Cengage Learning. Kindle Edition.

Answer 1

Answer:

1.

r market = 0.12 or 12%

2.

r stock = 0.12 or 12%

3.

r Stock = 0.169 or 16.9%

Explanation:

The required rate of return can be calculated using the CAPM or Capital asset pricing model equation. The formula for required rate of return under this model is,

r = rRF + Beta * rpM

Where,

• rRF is the risk free rate
• rpM is the risk premium on market
• r represents the required rate of return

1.

The beta of the market is always considered to be 1. Thus, the required rate of return on market would be,

r market = 0.05 + 1 * 0.07

r market = 0.12 or 12%

2.

For a stock whose beta is 1.0, the required rate of return would be same as that for market. So, the required rate of return for a stock with a beta of 1.0 is,

r Stock = 0.05 + 1 * 0.07

r Stock = 0.12 or 12%

3.

The required rate of return for a stock with a beta of 1.7 is,

r Stock = 0.05 + 1.7 * 0.07

r Stock = 0.169 or 16.9%