Question

Beta and required rate of return

A stock has a required return of 16%; the risk-free rate is 6.5%; and the market risk premium is 6%.

1. What is the stock's beta? Round your answer to two decimal places.
   
   
2. If the market risk premium increased to 10%, 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 greater than 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 less than 1.0, then the change in required rate of return will be greater 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 less than the change in the market risk premium.
   4. 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.
   5. 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.
   
   -Select-IIIIIIIVVItem 2
   
   New stock's required rate of return will be  %. Round your answer to two decimal places.

Answer 1

Based on CAPM,

Expected return on Stock = Risk free rate + Beta * Market risk premium

a) 16% = 6.5% + Beta * 6%

9.5% = Beta * 6%

Beta = 1.5833

Beta = 1.58 --> Answer

b) Based on the CAPM relation above, expected return on stock is directly related to market risk premium. If market risk premium increases, so would the expected return on stock would increase. Increase would be influnced by Beta of the stock.

Based on relation, correct statement is Statement 1.

Required Return = 6.5% + 1.5833 * 10%

Required return = 22.33%