Question

Investors expect the market rate of return in the coming month to be 3.2%. The T-bill rate is 0.5%. Firm Ashwood with a beta of 1.2 had a fire this month which caused it a loss of $8 million according to the current estimation. If the loss turns out to be $10 million in the further investigation next month, what is your best guess as to the rate of return that will be earned on Ashwood’s stock. The market value of its outstanding equity is $800 million.

		3.5%
		4.0%
		2.5%
		5.0%

Answer 1

3.5%

The required rate of return R(e) is calculated by CAPM model

R(e) = r(f) + Beta*(R(m) - r(f))

R(m) is the market return =3.2%

r(f) is the risk-free rate = 0.5%

R(e) = 0.005+1.2*(0.032-0.005)

R(e) = 0.0374 = 3.74%

The market value of its outstanding equity is $800 million

R(e) *  market value of its outstanding equity = 0.0374*$800 million = $29.92 million

If there is a further loss of $2 million ( $10million - $8 million), the the market value of outstanding equity is expected to decrease by $2 million

New market value of its outstanding equity = $27.92 million

Expected rate of return of Ashwood’s stock = $27.92 million / $798 million = 0.0350 = 3.5%