Question

The CFO of Ramekin Pottery Inc. is concerned about holding up the price of the company’s stock. He’s asked you to do an analysis starting with an estimate of the return investors are likely to require before they will invest in the firm. The overall stock market is currently returning 16%, 90 day treasury bills yield 6%, and the return on Ramekin’s stock typically responds to changes in the political and economic environment only about 60% as vigorously as does that of the average stock. a. Prepare an estimate of the firm’s required return using the CAPM. b. Is a higher or lower required return good for the company? Why? c. Suppose the CFO asks you what management can do to improve the required return. How will you respond? d. What will you tell him if he wants it done in within the next three months?

Answer 1

Here, we analyze the company stock using CAPM model

a) Here, the market rate of return R(m) is 16% ( Overall stock market return)

The risk-free rate R(f) calculated from 90-day treasury bills is 6%

The beta of the stock is 0.6 ( Since the company stock shows 60% correlation with the macro-economic changes)

According to the CAPM model, the required rate of return on a stock R(e) is

R(e) = R(f) + Beta * (R(m) -R(f))

R(e) = 0.06+0.6*(0.16*0.06) = 6.58%

b) A lower required rate is good for the company. This is because the required rate is calculated basis the risk the company is facing. Higher the risk, higher the Beta and hence higher the required rate of return. A more stable and less risky company has a lower required rate of return.

c) The required rate is directly proportional to the riskiness of the stock. Hence to improve the required rate of return, risk in the firms must be reduced. External or market risk is indicated by Beta. Higher the correlations with the markets and external events, the higher the required rate of return. Hence the company needs to make the company less prone to the political and economic environment by taking up projects which are less exposed to market risks.

d) The change in the required rate of return is based on the company's stock returns over the past several time period which also depends on company's growth prospects and risk factors. Any substantial change in the required rate of return takes longer time period mainly because of the company's return correlation with the market returns takes several time-period to change. Hence in the short-term of 3 months, it is possible to tweak company's business to improve the required rate, however, a substantial change cannot be expected in a short-time period.