Question

4. All else equal, which of the following statements is CORRECT?
A. The company’s value decreases as Beta declines.
B. The company’s value increases as Beta declines.
C. The company’s value is unaffected by changes in the Beta.
D. The company’s value increases as the Beta increases.

5. An analyst has collected the following information:
- The risk-free rate is 5.5 percent.
- The market risk premium is 5 percent.
- The stock’s beta is 1.4.
What is the company’s cost of equity?
A. 7.7%
B. 12.5%
C. 15.3%
D. 17.1%

6. The estimated beta for RDG is 0.74. The risk free rate of return is 4 percent and the Equity
Risk Rremium is 5 percent. What is the required rate of return for RDG using the CAPM?
A. 15.2%
B. 12.3%
C. 10.1%
D. 7.7%

Answer 1

Note:- As per answering guidelines, only the first question out of above has been answered.

Solution- 4

Relationship between beta and market value:

There is an inverse relationship between a stock's beta and it's valuation. Beta essentially refers to the risk in a stock investment, and as the beta (risk) goes up, the value that market is willing to pay for the stock goes down. Similarly, when the beta (risk) goes down, the value that market is willing to pay for the stock goes up.

In other words, We know higher risk means higher expected return on investment and vice-versa. So, if a stock's beta (risk) goes up, the expected return for investors goes up and hence the value of the stock goes down. On the contrary, when the beta (risk) goes down, the expected return for investors goes down and hence the value of the stock goes up.

Analysis of various options (Based on above explanation):-

Option A: Based on above explanation, the company's value increases as the beta (risk) declines. As explained above, this is because the decrease in beta or risk reduces the expected return for investors which pushes the company's market value higher. Therefore, this option is not correct.

Option B: Based on above explanation, the company's value increases with decline in beta or risk. Again, this is because the decrease in beta means decrease in risk and thus the expected return for investors goes down resulting in increase in company's value. Hence, this option is correct.

Option C: When the beta changes, the risk and expected return in the investment changes, therefore the value of the company must also change and therefore, this option is not correct.

Option D: Based on above explanation, when the beta goes up, the risk increases which pushes the value of the company downwards. Therefore, this option is not correct.

Therefore, only option B is correct.