Question

Stock R has a beta of 1.5, Stock S has a beta of 0.85, the expected rate of return on an average stock is 13%, and the risk-free rate is 4%. By how much does the required return on the riskier stock exceed that on the less risky stock? Do not round intermediate calculations. Round your answer to two decimal places.

Answer 1

Required rate of return of stock R

The required return on 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 = 4% + 1.5*(13% - 4%)

= 4% + 13.50%

= 17.50%

Required rate of return of stock S

The required return on 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 = 4% + 0.85*(13% - 4%)

= 4% + 7.65%

= 11.65%

Difference between the required return of both the stock:

= 17.50% - 11.65%

= 5.85%.

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