Question

The stock of WeAllWantToBeFinanceStudents Company has a beta of 0.5. The current risk-free rate of return is 2.75% and the market risk premium is 6%. SHOW ALL WORK FOR FULL CREDIT. a) (6 pts) What is the required rate of return on this stock? b) (4 pts) If the expected rate of return on the stock investment is 6%, is this a good buy or a bad buy? Explain fully.

Answer 1

a) Calculation of Required Rate of Return

b) When Expected Return is 6% is this a good or a bad buy

Expected Return can be defined as the return the firm can earn on its retained earnings. It is the return provided by market.

Required Rate of Return is the return that stockholders want on their investment.

When Expected Return is higher than required rate of return the stock will provide a higher return than what we require. Therefore investor should buy the stock.

In the given case as expected return (6%) is greater than required rate of return (5.75%) it would be a good buy.

As per Capital Asset Pricing Model (CAPM) Re = Rf + (Rm-Rf) B Where Re = Required return of stock Rf = Risk free rate of return Rm-Market Return Rm - Rf = Market Risk Premium B-Beta of the stock Calculation of Expected Return of stock Rf = 2.75% Rm-Rf = 6% B = 0.5 Using the formula Re = Rf + (Rm-Rf) B Re = 2.75 +6 * 0.5 Re = 2.75 +3 Re = 5.75%