Question

The Treasury bill rate is 5%, and the expected return on the market portfolio is 10%. According to the capital asset pricing model:

Required:
a. What is the risk premium on the market?
b. What is the required return on an investment with a beta of 1.5?
c. If an investment with a beta of 0.7 offers an expected return of 8.0%, does it have a positive or negative NPV?
d. If the market expects a return of 11.5% from stock X, what is its beta?

Answer 1

a) Re = Rf + [beta x (Rm - Rf)

10% = 5% + [1 x (Rm - 5%)]

5% = Rm - 5%

Rm = 10%

risk premium = Rm - Rf = 5%

b) Re = 5% + (1.5 x 5%) = 12.5%

c) Re = 5% + (0.7 x 5%) = 8.5%

since Re is lower than the expected return of the project, the NPV is positive.

d) 11.5% = 5% + (beta x 5%)

6.5% = beta x 5%

beta = 6.5% / 5% = 1.3