Question

Porter Plumbing's stock had a required return of 11.00% last year, when the risk-free rate was 5.50% and the market risk premium was 4.75%. Then an increase in investor risk aversion caused the market risk premium to rise by 2%. The risk-free rate and the firm's beta remain unchanged. What is the company's new required rate of return? (Hint: First calculate the beta, then find the required return.)

Answer 1

The expected return is calculated using the Capital Asset Pricing Model (CAPM) which is calculated using the formula below:

Ke=Rf+[E(Rm)-Rf]

Where:

Rf=risk-free rate of

Rm=expected rate of return on the market.

Rm- Rf= Market risk premium

= stock’s beta

The question is solved by first calculating the beta.

11%= 5.50% + b*4.75%

= 11% - 5.50%/ 4.75%

= 5.50%/ 4.75%

= 1.1579.

New market risk premium= 4.75% + 2%

                                         = 6.75%

New required rate of return is calculated as below:

Ke= 5.50% + 1.1579*6.75%

     = 5.50% + 7.8158%

     = 13.3158%   13.32%.

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