Question

1.1) The beta coefficient of Gans Ltd share is 0.9 and Handy Ltd share S has a beta of

Answer 1

Answer:

1. The riskier stock is the one with the higher beta which is Handy Ltd.

Use CAPM to calculate the required return on both stocks. The formula is:

Required return = Risk free rate + beta * (market return - risk free rate)

Gans Ltd Stock                                                         Handy Ltd Stock

= 4% + 0.9 * ( 10% - 4%)                                              = 4% + 1.8 * (10% - 4%)

= 9.4%                                                                         = 14.8%

Difference = 14.8 - 9.4

= 5.4%

2. a. Expected return

Expected return is a weighted average of the returns given the probability of the different state of economies.

= (0.25 * 18%) + (0.4 * 5%) + (0.35 * -2%)

= 0.045 + 0.02 - 0.007

= 5.8%

b. Required return

Using CAPM like in question 1:

Required return = Risk free rate + beta * (market return - risk free rate)

= 4% + 1.2 * ( 10% - 4%)

= 11.2%

c. The asset should not be purchased because its expected return is lower than its required return. This means that the stock is not providing enough return for the risk incurred.