Question

2) The market return, based on a broad market index, is estimated to be 15%. Calculate Company ABC’s required return if the risk-free rate is 4% and the stock’s beta is 1.35 (round your answer to two decimal places). (i) Describe the assumptions related to the problem: (ii) Apply the appropriate mathematical model: (iii) Calculation:

Answer 1

To solve the problem the Capital Asset Pricing Model is being utalised.

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Assumption Related to the Problems:

1) Market Return : Market returns for stocks are based on factors such as business risk, liquidity risk, and financial risk. Or, you can derive it from historical yearly market returns. just like in the question Based on Broad Market Index.

2)Risk Free Rate : The risk-free rate of return is the theoretical rate of return of an investment with zero risk. The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time.

In theory, the risk-free rate is the minimum return an investor expects for any investment because he will not accept additional risk unless the potential rate of return is greater than the risk-free rate.

  In practice, however, the risk-free rate does not exist because even the safest investments carry a very small amount of risk. Thus, the interest rate on a three-month U.S. Treasury bill is often used as the risk-free rate for U.S.-based investors

3) Beta : Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Beta is used in the capital asset pricing model (CAPM), which calculates the expected return of an asset based on its beta and expected market returns. Beta is also known as the beta coefficient.

Calculating 'Beta' : Beta is calculated using regression analysis. Beta represents the tendency of a security's returns to respond to swings in the market. A security's beta is calculated by dividing the covariance the security's returns and the benchmark's returns by the variance of the benchmark's returns over a specified period.