Question

Plaid Pants, Inc. common stock has a beta of 0.90, while Acme Dynamite Company common stock has a beta of 1.80. The expected return on the market is 10 percent, and the risk-free rate is 6 percent. According to the capital-asset pricing model (CAPM) and making use of the information above, the required return on Plaid Pants' common stock should be __________ and the required return on Acme's common stock should be ___________. (Please

show me the process. Thanks!)

Answer 1

Solution:

Calculation of Required Return of Plaid Pants Inc. :

As per the Capital Asset Pricing Model ( CAPM ) the required rate of return of a given stock is calculated using the following formula:

RR= R_F + [ β * ( R_M - R_F ) ]

Where

RR = Required rate of return ; R_F = Risk free rate   ; β = Beta of the stock ;  

R_M = Expected Return on the market

As per the information given in the question w.r.t Plaid Pants, Inc. we have

R_F = 6 %   ; R_M = 10 %   ; β = 0.90

Applying the above values in the formula we have

= 6 % + [ 0.90 * ( 10 % - 6 % ) ]

= 6 % + [ 0.90 * ( 4 % ) ]

= 6 % + 3.6 %

= 9.6 %

Thus, the required rate of return of common stock of Plaid Pants, Inc. = 9.6 %

Calculation of Required Return of Acme Dynamite Company :

As per the Capital Asset Pricing Model ( CAPM ) the required rate of return of a given stock is calculated using the following formula:

RR= R_F + [ β * ( R_M - R_F ) ]

Where

RR = Required rate of return ; R_F = Risk free rate   ; β = Beta of the stock ;  

R_M = Expected Return on the market

As per the information given in the question w.r.t Acme Dynamite Company, we have

R_F = 6 %   ; R_M = 10 %   ; β = 1.80

Applying the above values in the formula we have

= 6 % + [ 1.80 * ( 10 % - 6 % ) ]

= 6 % + [ 1.80 * ( 4 % ) ]

= 6 % + 7.2 %

= 13.2 %

Thus, the required rate of return of common stock of Acme Dynamite Company = 13.2 %