Question

Beale Manufacturing Company has a beta of 2.5, and Foley Industries has a beta of 0.95. The required return on an index fund that holds the entire stock market is 12.5%. The risk-free rate of interest is 3.25%. By how much does Beale's required return exceed Foley's required return? Do not round intermediate calculations. Round your answer to two decimal places.

Answer 1

Required return of Beale:

The expected return on a stock is calculated using the Capital Asset Pricing Model (CAPM)

The formula is given below:

Ke= Rf+b[E(Rm)-Rf]

where:

Rf= risk-free rate of return

Rm= expected rate of return on the market.

Rm-Rf= Market risk premium

b= Stock’s beta

Ke= 3.25% + 2.5*(12.5% - 3.25%)

= 3.25% + 23.1250%

= 26.3750%

Required return of Foley:

The expected return on a stock is calculated using the Capital Asset Pricing Model (CAPM)

The formula is given below:

Ke= Rf+b[E(Rm)-Rf]

where:

Rf= risk-free rate of return

Rm= expected rate of return on the market.

Rm-Rf= Market risk premium

b= Stock’s beta

Ke= 3.25% + 0.95*(12.5% - 3.25%)

= 3.25% + 8.7875%

= 12.0375%   

= 26.3750% - 12.0375%   

= 14.3375% 14.34%.

Therefore, Beale's required return exceeds Foley's required return by 14.34%.