Harris has an estimated beta of 1.13. Currently, the short-term treasury interest rate is 0.8% per year. Historically, returns to a broadly diversified portfolio of stock market investments have averaged 10.6% per year, and short term treasury interest rates have averaged 3.4% per year. Based on a survey of investment management professionals, the expected return to the broadly diversified market over the next several years is 6.8% per year. (a) What estimate of the market risk premium is supported by the historical evidence? (b) What estimate of the market risk premium is supported by investment management survey? (c) Relying on the CAPM, and the investment management survey, what is the expected rate of return on Harris common stock?
a) Market risk premium = ( expected Return - risk Free rate)/
Beta = (10.6%-3.4%)/1.13 = 6.37%
b) Market risk Premium = ( Expected Return by Investment Management - risk Free rate)/ Beta = (6.8%-3.4%)/1.13 = 3.01%
c) Expected Return on management survey assuming risk free rate at 0.8% = Risk Free rate + Beta * market Risk Premium
= 0.8%+1.13*3.01% = 4.20%
Expected Return on management survey assuming risk free rate at 3.4% = Risk Free rate + Beta * market Risk Premium
= 3.4%+1.13*3.01% = 6.80%
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