Question

Required rate of return: As an equity analyst you are concerned with what  will happen to the required return to Universal Toddler Industries’s stock as  market conditions change. Suppose r RF= 8%, r M= 12%, and b UTI= 1.4.  

a. Under current conditions, what is r UTI , the required rate of return on UTI stock?  

b. Now suppose r RF (1) increases to 9% or (2) decreases to 7%. The slope of the  SML remains constant. How would this affect r M and r UTI ?

c. Now assume r RF remains at 8% but r M (1) increases to 15% or (2) falls to  10%. The slope of the SML does not remain constant. How would these  changes affect r UTI ?

Answer 1

Answer a)

Required rate of return = Rf + Beta * (Return on Market - RF)

RF= 8%

RM= 12%

Beta=1.4

=8% + 1.4*(12%-8%)

=13.6%

Answer b)

Part (1) Risk Free Rate increases to 9% , then RM increases proportionately to 13% since slope remains constant.

Required rate of return = Rf + Beta * (Return on Market - RF)

= 9% + 1.4*(13%-9%)

=14.6%

Part (2) Risk Free rate decreases to 7%, then RM decreases proportionately to 11% since slope remains constant.

=7%+1.4*(11%-7%)

=12.6%

Answer c)

Part (1) Return on market increase to 15% and slope does not remain constant and no change to Rf.

Required rate of return = Rf + Beta * (Return on Market - RF)

= 8% + 1.4*(15%-8%)

= 17.8%

Part (2) Return on market falls to 10% and slope does not remain constant and no change to Rf.

= 8% + 1.4* (10%-8%)

= 10.8%