Question

Stock A has an 8.5% expected rate of return and a beta coefficient of 0.85. Stock B has a 10.5% expected rate of return and a beta coefficient of 1.05. The risk-free rate is 4.5% and the market risk premium is 5%.

A) What are the required rates of return for Stocks A and B?

B) Would you buy these stocks and why?

Please show all work

Answer 1

Answer A - Required return of stock A is 8.75% and Stock B is 9.75%

Reason -

CAPM FORMULA =

Required return = Risk free rate + beta * market premium.

so,

Required return of stock A = 4.5% + 0.85 * 5%

= 4.5% + 4.25 %

= 8.75%

Required return of stock B = 4.5% + 1.05 * 5%

= 4.5% + 5.25%

= 9.75%

Answer B - we would like to buy Stock B only because it have a higher expected rate of return than it's Required rate of return or theoretical rate of return. Which means for the risk we are taking on stock B, it's expected to cover that risk and offer a higher return than the required rate of return. So the return justifies the risk taken.

In case of stock A the required rate of return is 8.75% but the stock is expected to return 8.5% for the risk taken on stock, so the Investment doesn't justifies the risk taken on it. So we will not invest in stock A.