Question

If a company's β is 0.6, the expected risk-free return is 10%, and the expected market return is 20%, compute the company's required return and risk premium.

Answer 1

Information provided:

Beta= 0.6

Risk free rate= 10%

Expected market return= 20%

Risk premium is computed using the below formula:

= Expected return on the market – Risk free rate

= 20% - 10%

= 10%.

The required return is computed using the capital asset pricing model.

The formula for calculating the required return using capital asset pricing model is given below:

Ke=Rf+b[E(Rm)-Rf]

Where:

Rf=risk-free rate of return

Rm=expected rate of return on the market.

B= Beta of the company

Ke= 10% + 0.6*(20% - 10%)

     = 10% + 6%

     = 16%.

Therefore, the expected return is 16%.

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