Question

Catherine Middleton has assessed the following information relevant to an investment analysis of Eggplant Produce Trading shares:

Risk-adjusted required rate of return for Eggplant Produce Trading shares = 16.6%

Rate of return on treasury bonds = 4%

Expected return on the market portfolio = 10%

Forecast investment return for Eggplant Produce Trading shares = 19%

Required:

(1) What is the beta of Eggplant Produce Trading shares?

(2) Based on your prior discussion, should Catherine be deciding to; hold, buy or sell shares in the company?

(3) Given an unchanged expected return on the market portfolio and beta for the company, what would you expect to happen to the risk-adjusted required rate of return for Eggplant Produce Trading shares if the rate of return on treasury bonds increased to 6%?

Answer 1

1) As per CAPM

Risk adjusted required return = Risk free rate + ( Market return - Risk free rate ) * Beta

16.60 = 4 + ( 10 - 4 ) * beta

Beta = ( 16.60 - 4 ) / 6

Beta = ( 16.60 - 4 ) / 6

         = 2.1 Answer

2) Since expected return on Shares (19%) is more than required returns(16.60%), Catherine Middleton should hold the shares.

3) As per CAPM

Risk adjusted required return = Risk free rate + ( Market return - Risk free rate ) * Beta

= 6 + ( 10 - 6 ) * 2.10

= 6 + 4 / 2.10

= 7.90% Answer