Question

You are applying a three factor model to determine a required return based on three risk factors.
The model looks as follows:

Req. Ret. = R_rf + Beta_Spread * Factor_Spread + Beta_Size * Factor_Size + Beta_MB * Factor_MB

If Factors in the equation are risk premiums, then what is the Required Return if the following inputs are used?

Risk-free rate = 2%
Beta_Spread  = 1.5
Beta_Size = 1.0
Beta_MB = 0.75

Expected Long-Term Yield Return (Spread) = 5%
Expected Firm Size Return (Size) = 3%
Expected Market to Book Return (MB) = 7%

Group of answer choices

5.25%

7.50%

11.25%

17.75%

Please be very, very thorough in your explanation, and use excel if applicable instead of a financial calculator please and thank you.

Answer 1

Required return:

= 2%+1.5×5%+1×3%+0.75*7%

= 2%+7.5%+3%+5.25%

= 17.75%

Hence, correct option is 17.75%

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