Question

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's Stock - D REQUIRED RATE OF RETURN (Percent) 2 0.5 1.5 1.0 RISK (Beta)

Return on HC's Stock - Coordinates (1.2, 10.4)
Blue line - Slope is 4.5, Y-Intercept is 5.

CAPM Elements	Value
Risk-free rate (rRFrRF)	(10.4% / 2.8% / 5% / 5.5%)
Market risk premium (RPMRPM)	(4.5% / 5.9% / 8.1% / 3.4%)
Happy Corp. stock’s beta	(1.9 / 0.3 / 1.2 / 2.8)
Required rate of return on Happy Corp. stock	(8.8% / 9.4% / 13% / 10.4%)

An analyst believes that inflation is going to increase by 2.0% over the next year, while the market risk premium will be unchanged. The analyst uses the Capital Asset Pricing Model (CAPM). The following graph plots the current SML.

Calculate Happy Corp.’s new required return. Then, on the graph, use the green points (rectangle symbols) to plot the new SML suggested by this analyst’s prediction.

Happy Corp.’s new required rate of return is (8.7% / 28.5% / 13.6% / 12.4%).

Answer 1

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Answer:

SOLUTION: Value 5% Particulars Risk free rate Market risk premium Happy Corp. stock beta Required rate of return 1.2 10.4% Justification: The risk free rate is the vertical intercept of the SML, and the market risk premium is the slope of the SML. The risk free rate is on 5% that is the vertical side where the line starts. Beta is on the horizontal line. The required rate of retum is 10.4% where the beta and risk free rate intersect. Using the CAPM formula the market risk premium is 4.5% is found. Required return =Risk free rate+Betax Market risk premium 10.4% = 5% +1.2x Market risk premium Market risk premium =4.5% The required rate of retum is 12.4% Justification: Required return = Risk free rate + Beta Market risk premium =(5% +2%) +1.2x 4.5% = 12.4% The answer is the risk free rate remains constant. Justification: The risk-free rate (I'RF) is the vertical intercept of the SML. Increased risk aversion will cause the slope of the SML to become steeper; however, the vertical intercept will remain the same. Consequently, the risk-free rate will remain constant when there is a change in risk- aversion.

Since the investors are not averse to risk there will be no risk premium. Therefore, SML is going to be horizontal. The slope of the SML line will be zero. Answer: The SML would be a horizontal line.