Porter Plumbing's stock had a required return of 10.25% last year, when the risk-free rate was 5.50% and the market risk premium was 4.75%. Then an increase in investor risk aversion caused the market risk premium to rise by 2%. The risk-free rate and the firm's beta remain unchanged. What is the company's new required rate of return?
As per Capital Asset pricing Model:
E(R) = Rf +Beta * ( Rm - Rf )
Where
E(R) = Expected rate of return = 10.25%
Rf = Risk free rate = 5.50%
(Rm - Rf) = Risk premium = 4.75%
From this, we need to caluculate Beta
10.25% = 5.50% + Beta * (4.75%)
Beta = 1
Next,we need to caluculate new required rate of return,
For this,
(Rm - Rf) = Risk premium = 6.75% i.e (4.75%+2)
Now
Required rate of return = 5.50% + 1 * ( 6.75% )
Required rate of return = 12.25%
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