Question

1.1) The beta coefficient of Gans Ltd share is 0.9 and Handy Ltd share S has a beta of

1.8. The expected return on an average stock is 10%, the risk free rate is 4%. By how much
does the required return on the riskier stock exceed the required return on the less risky
stock?

You are given the following information on Daffy Ltd share and are required to answer the
questions that follow
State of economy
Boom
Normal
Bust
Probability
0.25
0.40
0.35
Return(%)
18
5
(2)
The risk free rate of interest is 4%, the return on the market is 10% and the beta of the firm is
1.2.
a) Calculate the expected return.
b) Calculate the required retum.
c) Explain whether the above asset should be purchased

Answer 1

1. The riskier stock is the one with the higher beta which is Handy Ltd.

Use CAPM to calculate the required return on both stocks. The formula is:

Required return = Risk free rate + beta * (market return - risk free rate)

Gans Ltd Stock Handy Ltd Stock

= 4% + 0.9 * ( 10% - 4%) = 4% + 1.8 * (10% - 4%)

= 9.4% = 14.8%

Difference = 14.8 - 9.4

= 5.4%

2. a. Expected return

Expected return is a weighted average of the returns given the probability of the different state of economies.

= (0.25 * 18%) + (0.4 * 5%) + (0.35 * -2%)

= 0.045 + 0.02 - 0.007

= 5.8%

b. Required return

Using CAPM like in question 1:

Required return = Risk free rate + beta * (market return - risk free rate)

= 4% + 1.2 * ( 10% - 4%)

= 11.2%

c. The asset should not be purchased because its expected return is lower than its required return. This means that the stock is not providing enough return for the risk incurred.