Question

BETA AND REQUIRED RATE OF RETURN

A stock has a required return of 12%; the risk-free rate is 7%; and the market risk premium is 3%.

1. What is the stock's beta? Round your answer to two decimal places.
   
   
2. If the market risk premium increased to 7%, what would happen to the stock's required rate of return? Assume that the risk-free rate and the beta remain unchanged.
   1. If the stock's beta is equal to 1.0, then the change in required rate of return will be greater than the change in the market risk premium.
   2. If the stock's beta is equal to 1.0, then the change in required rate of return will be less than the change in the market risk premium.
   3. If the stock's beta is greater than 1.0, then the change in required rate of return will be greater than the change in the market risk premium.
   4. If the stock's beta is less than 1.0, then the change in required rate of return will be greater than the change in the market risk premium.
   5. If the stock's beta is greater than 1.0, then the change in required rate of return will be less than the change in the market risk premium.
   
   -Select-IIIIIIIVVItem 2
   
   New stock's required rate of return will be  %. Round your answer to two decimal places.

Answer 1

a.

As per CAPM Model,

Required Rate = R_f + Beta(R_m - R_f)

(R_m - R_f) = Risk Premium = 3%

R_f = 7%

Required Rate = 12%

So,

Beta = (12 - 7)/3

Beta = 1.67

b.

If Risk Premium = 7%

Required Rate = 7 + 1.67(7)

Required Rate = 18.69%

Required Rate = R_f + Beta(R_m - R_f)

If Beta > 1

Change in Required Rate is greater than Change in Risk Premium.

So Option III is correct.

If the stock's beta is greater than 1.0, then the change in required rate of return will be greater than the change in the market risk premium.

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