Question

4. Changes to the security market line 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. REQUIRED RATE OF RETURN (Percenti 20.0 16.0 Return on HC's Stock 12.0 8.0 4.0 0.0 0.5 10 1.5 2.0 RISK (Betal CAPM Elements Value Risk-free rate (rar) Market risk premium (RPe) Happy Corp. stock's beta Required rate of return on Happy Corp. stock 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 OUUUBctxream 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 Tool tip: Mouse over the points on the graph to see their coordinates REQUIRED RATE OF RETURN IPercentlh 20 New SML 16 12 0.8 1.2 1.4 0.0 0.4 20 RISK (Betal The SML helps determine the risk-aversion level among investors The flatter the slope of the SML, the the level of risk aversion Which of the following statements best describes the shape of the SML if investors were not at all risk averse? O The SML would have a negative slope O The SML would have a positive slope, but the slope would be flatter than it would be if investors were risk averse. O The SML would be a horizontal line. O The SML would have a positive slope, but the slope would be steeper than it would be if investors were risk Type here to search

Answer 1

Risk Free Rate=4%

Market Risk Premium=(9%-4%) or 5%

Harpy company's stock beta=1.25

Required of return= Rf+Beta*RPm= 4%+1.25*5%=10.25%

If the inflation rate is going to increase 2%, then it will be adjusted in risk free rate. SO, new risk free rate=4%+2%=6%

So, New required rate of return=6%+1.25*5%=12.25%

The flatter the slope of SML line, the less the level of risk aversion. (As investor are willing to take more risk for less return)

The SML would be horizontal line. (Where the investor is not at all risk averse)