Question

A stock has a required return of 12%, the risk-free rate is 6%, and the market risk premium is 4%.

1. What is the stock's beta? Round your answer to two decimal places.
   
   
2. If the market risk premium increased to 8%, what would happen to the stock's required rate of return? Assume that the risk-free rate and the beta remain unchanged. Do not round intermediate calculations. Round your answer to two decimal places.
   1. 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.
   2. 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.
   3. 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.
   4. 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.
   5. 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.
   
   
   New stock's required rate of return will be   %.

Answer 1

(A) Computation of Stock beta

As per CAPM, the equation for calculation of required rate of return is as follows:

Required return = Risk free rate +Beta *Market risk premium

12% = 6% + Beta * 4%

Beta = (12 - 6)/ 4

Beta = 1.5

(B) Change in required rate of return = New return - Old return = 18% - 12% =6%

Change in market risk premium = New market premium - Old market premium = 8% - 4% = 4%

Hence, Option IV is correct i.e. 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.

(C) Computation of new stock's required return

New stock's required return = Risk free rate +Beta *Market risk premium

= 6% + 1.5 * 8%

= 18%