Question

The security market line is estimated to be k=4% + (12.7% - 4%)β.

You are considering two stocks. The beta of A is 1.3. The firm offers a dividend yield during the year of 3 percent and a growth rate of 7.6 percent. The beta of B is 1.5. The firm offers a dividend yield during the year of 4 percent and a growth rate of 6.9 percent.

What is the required return for each security? Round your answers to two decimal places.

Stock A: %

Stock B: %

Why are the required rates of return different? The difference in the required rates of return is the result of -Select- being riskier.

Since A offers higher potential growth, should it be purchased? Stock A -Select- be purchased. S

ince B offers higher dividend yield, should it be purchased? Stock B -Select- be purchased.

Which stock(s) should be purchased? -Select- should be purchased.

Answer 1

Security market line represents the CAPM return or required return.

	Stock A	Stock B
Beta	1.3	1.5
dividend yield	3%	4%
Growth	7.60%	6.90%

As per CAPM, required return = Risk Free rate + Beta * [ market return-Risk free return]

Required return = return as per CAPM =  4% + (12.7% - 4%)β

4% = Risk Free rate

12.7% = Market return

β = Beta

hence

Required return of Stock A =  4% + (12.7% - 4%)β = 4% + (12.7% - 4%)*1.3 = 15.31%

Required return of Stock B =  4% + (12.7% - 4%)β = 4% + (12.7% - 4%)*1.5 = 17.05%

Why are the required rates of return different?

The difference in the required rates of return is the result of Difference In Beta.

Expected Return on stock (K) =

D1 = next Dividend

P0 = Current price

g = growth rate

dividend yield = Next Dividend / Current price

hence we can say that   is Nothing but the Dividend yield

hence Expected retrun on stock = Dividend Yield + growth rate

You should buy the stock which has expevted return more than the Required rate of return.

Expected retrun on stock A = 3%+7.60% = 10.60%

Expected retrun on stock B = 4% +6.90% = 10.90%

.	Stock A	Stock B
Minimum required return	15.31%	17.05%
Expected return	10.60%	10.90%
Purchase or Not	Dont Purchase	Dont Purchase
Reason	as Expected return < Required return	as Expected return < Required return

NO STOCK TO BE PURCHASED