Question

Beta and required rate of return

A stock has a required return of 12%; the risk-free rate is 2.5%; and the market risk premium is 3%.

What is the stock's beta? Round your answer to two decimal places.

B. If the market risk premium increased to 9%, what would happen to the stock's required rate of return? Assume that the risk-free rate and the beta remain unchanged.

1. If the stock's beta is equal to 1.0, then the change in required rate of return will be greater than the change in the market risk premium.

2. If the stock's beta is equal to 1.0, then the change in required rate of return will be less than the change in the market risk premium.

3. If the stock's beta is greater than 1.0, then the change in required rate of return will be greater than the change in the market risk premium.

4. If the stock's beta is less than 1.0, then the change in required rate of return will be greater than the change in the market risk premium.

5. If the stock's beta is greater than 1.0, then the change in required rate of return will be less than the change in the market risk premium.

-Select-

New stock's required rate of return will be _______ %. Round your answer to two decimal places.

Answer 1

A. As per CAPM,

Required Return = Risk Free rate + (Market Return - Risk Free Rate ) * Beta

= Risk Free rate + (Market Risk Premium ) * Beta

12 % = 2.5% + (3% ) *Beta

Or Beta = 9.5% / 3%

= 3.16666

= 3.17

Hence the correct answer is 3.17

B.If the market risk premium increased to 9%,

Required Return = Risk Free rate + (Market Return - Risk Free Rate ) * Beta

= Risk Free rate + (Market Risk Premium ) * Beta

= 2.5 % + ( 9% ) * 3.17

= 31.03

The stock’s beta is greater than 1,

change in required rate of return = 31.03% - 12%

= 19.03%

change in the market risk premium = 9% -3%

=6%

Change in the required rate of return  is greater than the change in the market risk premium

Hence the correct answer is :

If the stock's beta is greater than 1.0, then the change in required rate of return will be greater than the change in the market risk premium.

New stock's required rate of return will be:

Required Return = Risk Free rate + (Market Return - Risk Free Rate ) * Beta

= Risk Free rate + (Market Risk Premium ) * Beta

= 2.5 % + ( 9% ) * 3.17

= 31.03

Hence the correct answer is 31.03%