Question

Harrison Solar Inc. (HSI) has an estimated beta of 1.13. Currently, the short-term treasury interest rate is 0.8% per year. Historically, returns to a broadly diversified portfolio of stock market investments have averaged 10.6% per year, and short term treasury interest rates have averaged 3.4% per year. Based on a survey of investment management professionals, the expected return to the broadly diversified market over the next several years is 6.8% per year.

(a) What estimate of the market risk premium is supported by the historical evidence?

(b) What estimate of the market risk premium is supported by investment management survey?

(c) Relying on the CAPM, and the investment management survey, what is the expected rate of return on HSI common stock?

Answer 1

A)Market risk premium is supported by the historical evidence =Market return -Risk free rate

                                                         = 10.6 - 3.4

                                                         = 7.20%

b) market risk premium is supported by investment management survey = Market return -Risk free rate

                                                       = 6.8 -.8

                                                       = 6 %

c) expected rate of return on HSI common stock =Risk free rate + [Market risk premium * Beta]

                                                          = .80 + [6*1.13]

                                                         = .80 + 6.78

                                                         = 7.58%

Answer 2

(a) The estimate of the market risk premium supported by the historical evidence is:

Market Risk Premium = Average Stock Market Return - Short-term Treasury Interest Rate Market Risk Premium = 10.6% - 3.4% Market Risk Premium = 7.2%

(b) The estimate of the market risk premium supported by the investment management survey is:

Market Risk Premium = Expected Stock Market Return - Short-term Treasury Interest Rate Market Risk Premium = 6.8% - 0.8% Market Risk Premium = 6.0%

(c) According to the Capital Asset Pricing Model (CAPM), the expected rate of return on HSI common stock can be calculated as:

Expected Return on HSI Stock = Risk-free Rate + Beta × Market Risk Premium

Using the historical estimate of the market risk premium:

Expected Return on HSI Stock = 3.4% + 1.13 × 7.2% Expected Return on HSI Stock = 11.5%

Using the investment management survey estimate of the market risk premium:

Expected Return on HSI Stock = 0.8% + 1.13 × 6.0% Expected Return on HSI Stock = 7.8%

Therefore, the expected rate of return on HSI common stock is estimated to be between 7.8% and 11.5%, depending on which estimate of the market risk premium is used.