Question

Kamath Manufacturing Company has a beta of 1.45, while Gehr Industries has a beta of 0.85. The required return on stock market is 12.00%, and the risk-free rate is 6.00%. What is the difference between Kamath's and Gehr's required rates of return?

Answer 1

Solution:
	Difference between Kamath's and Gehr's required rates of return	3.60%
Working Notes:
	To get difference between Kamath's and Gehr's required rates of return, we have to compute required rate of return of each stock using CAPM.
	Kamath Manufacturing Company
	Cost of common equity (Ke)= rf + (rm - rf) x B
	rf = risk free rate = 6%
	Market rate of return =rm = 12.0%
	Beta = 1.45
	Kamath Manufacturing required rate of return (Ke)= rf + (rm - rf) x B
	Kamath Manufacturing required rate of return (Ke)=6%+ (12% - 6%) x 1.45
	Kamath Manufacturing required rate of return (Ke)=14.70%
	Gehr Industries Company
	Cost of common equity (Ke)= rf + (rm - rf) x B
	rf = risk free rate = 6%
	Market rate of return =rm = 12.0%
	Beta = 0.85
	Gehr Industries required rate of return (Ke)= rf + (rm - rf) x B
	Gehr Industries required rate of return (Ke)=6%+ (12% - 6%) x 0.85
	Gehr Industries required rate of return (Ke)=11.10%
	Difference between Kamath's and Gehr's required rates of return
	=Kamath required rate of return - Gehr required rate of return
	=14.70% - 11.10%
	=3.60%
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