Question

8. Changes to the security market line The following graph plots the current security market line (SML) and indicates the return that investors require from holding stock from Happy Corp. (HC). Based on the graph, complete the table that follows. Return on HC Stock REQUIRED RATE OF RETURN (Percent) RISK (Beta) CAPM Elements Value Risk free rate ( Market risk premium (RPM)

Answer 1

the SML , represented by

R= R_f + Beta * R_m-R_f

Risk free rate = 5%

Market risk premium =R_m-R_f = 8%-5%= 3% ......( market return at Beta=1, is 5% as per graph)

Happy corp Stock Beta= 1.2

Required return on Happy corp Stock= 5%+1.2*3%== 8.6%

with the increase of inflation rate by 2% , risk free rate will increase by 2%

new R_f = 5%+2% = 7%

Required return on Happy corp Stock= 7%+1.2*3% = 10.6%.

Option B :High Beta Stock