Question

A stock has a required return of 13%, the risk-free rate is 7.5%, and the market risk premium is 3%.

1. What is the stock's beta? Round your answer to two decimal places.
2. If the market risk premium increased to 7%, 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.

   Stock's required rate of return will be ? %.

Answer 1

a. Required Return = risk free rate + market risk premium*beta

13% = 7.5% + 3% * beta

Beta = (13%-7.5%)/3%

= 1.833333

Answer = 1.83

b. If the market risk premium increased to 7%, Required Return would be

= risk free rate + market risk premium*beta

= 7.5% + 7%* 1.83333

= 20.33%

Answer = 20.33%

change in required rate of return = 20.33%-13%

= 7.33%

change in the market risk premium = 7%-3%

= 4%

The change in required rate of return is greater than the change in the market risk premium and the beta is greater than 1.0

Hence the correct answer is :

II. 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.