Question

Calculate the required return for a stock after market returns
have changed:

Initial conditions: risk-free rate is 4%, the required return on
the market is 10%, and the beta is 1.20.

Risk aversion increases such that the market risk premium increases
by 1 percentage point, with no change in the risk-free rate.

Calculate the new required return. **(Do not round
intermediate calculations. Enter your answer as a percentage
rounded to 2 decimal places (e.g., 32.16).**

Answer #1

Required return is calculated as:

Required return=Risk-free rate+Beta*(Required return on the
market-Risk free rate)

Market risk premium=Required return on the market-Risk free
rate

Given that:

Risk free rate=4%

Required return on the market=10%

Beta =1.20

Required
return=4%+1.20*(10%-4%)=4%+1.20*(10%-4%)=0.04+1.20*0.06=0.112 or
11.20%

Now, market risk premium=Required return on the market-Risk free
rate

Required return on the market-Risk free rate=10%-4%=6%

So, market risk premium=6%

Now, market risk premium increases by 1 percentage point. It means,
the new market risk premium will be 6%+1%=7%

New required return=Risk free rate+Beta*(New market risk
premium)

Now, after substituting the values, we get:

New required return=4%+1.20*(7%)=0.04+1.20*0.07=0.124 or 12.40%

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