Question

You have also been asked to evaluate a specific stock: Russell Technology, Inc. (symbol RTI). You are considering a $300,000 investment in RTI stock. You need to assess the riskiness of RTI. The standard deviation for RTI returns is 21.25%. The standard deviation for the market is 15%. The correlation between RTI and the market is 0.60. The rate of return on a risk free security is 3%. The expected return on the market is 10%.
a. Using the Capital Asset Pricing Model, determine the required rate of return on RTI stock. (5 points).

b. Comment on the riskiness of RTI compared to the market. (2 points)

c. Assume the market is expected to fall by 5% next period. If you purchase $300,000 of RTI before the market decline, what is the dollar impact that you anticipate this market decline will have on KCI stock? (3 points)

Answer 1

BETA OF RTI = (CORRELATION BETWEEN RTI & MARKET)*(SD OF RTI)/(SD OF MARKET)

BETA OF RTI = (0.60)*(21.25)/(15) =0.85

(a)

REQUIRED RATE OF RETURN =

ke = Rf + beta (Rm -Rf)

ke = 3% + 0.85(15%-3%) = 3% + 0.85(12%) = 13.2%

(b) BETA OF RTI =0.85

RTI IS LESS RISKY IN COMPARISON TO MARKET

ACCORDING TO THEORY, IF BETA IS 0.85, THEN IT MEANS THAT IF MARKET CHANGES BY 1 %, THE STOCK OF RTI WILL CHANGE BY 0.85%.

SO IF MARKET GOES DOWN BY 1%, RTI STOCK WILL GO DOWN BY ONLY 0.85%

SAME WAY IF MARKET GOES UP BY 1%, RTI STOCK WILL MOVE UP BY 0.85% ONLY

SO RTI IS LESS RISKY THAN MARKET

(c) IF MARKET FALL BY 5%, THEN RTI STOCK WILL FALL BY = 5%(0.85) = 4.25%

PURCHASE VALUE OF RTI STOCK = $300000

THEREFORE DOLLAR IMPACT ON RTI STOCK = $300000 X 4.25% =$12750

VALUE OF STOCK OF RTI WILL GO DOWN BY $12750 ANSWER

NOTE : I THINK KCI STOCK IS WRITTEN BY MISTAKE IN SUM