Question

Suppose the market return is 8%, the risk-free rate is 1% and the beta for a given stock is 1.2. Answer the following questions based on this information:

What is the required return for this stock?

If the beta increases by 50% (but risk-free rate remains 1%), what will be the new required return for the stock? What is the percentage-wise change in required return compared to your answer to A) above?

If the market return increases by 50% (but beta remains at 1.2), what will be the new required return for the stock? What is the percentage-wise change in required return compared to your answer to A) above?

Answer 1

a)

Required rate of return using CAPM model = risk free rate + beta( expected market return - risk free rate)

Required rate of return = 0.01 + 1.2 ( 0.08 - 0.01)

Required rate of return = 0.01 + 0.084

Required rate of return = 0.094 or 9.4%

b)

When beta increases by 50%;

Beta = 1.5 ( 1.2) = 1.8

Required rate of return = 0.01 + 1.8 ( 0.08 - 0.01)

Required rate of return = 0.136 or 13.6%

change in return = (13.6% - 9.4%) / 9.4%

change in return = 44.6809%

c)

When market return increaes by 50%

market return = 1.5 ( 0.08) = 12%

Required rate of return = 0.01 + 1.2 ( 0.12 - 0.01)

Required rate of return = 0.142 or 14.2%

Change in require return = (14.2% - 9.4%) / 9.4%

Change in require return = 51.0638%