Question

Nagel Equipment has a beta of 0.88 and an expected dividend growth rate of 4.00% per year. The T-bill rate is 4.00%, and the T-bond rate is 5.25%. The annual return on the stock market during the past 4 years was 10.25%. Investors expect the average annual future return on the market to be 15.00%. Using the SML, what is the firm's required rate of return?

A) 13.83%
B) 13.55%
C) 11.62%
D) 11.76%
E) 14.94%

Answer 1

To find the required rate of return using the SML formula, we use the given risk-free rate, the stock's beta, and the expected market return. Upon computation, we find a rate of 13.68%. The closest given option is 13.55% (option B).

Step-by-step explanation:

Using the Security Market Line (SML) formula, we can calculate the firm's required rate of return. The SML is used in finance to determine the appropriate required rate of return of an asset, based on its risk level as measured by beta (β), taking into account the expected market return and the risk-free rate.

To calculate the required rate of return using the SML, we'll use the formula: required return = risk-free rate + β * (market return - risk-free rate).

In this case, the risk-free rate will be the T-bill rate which is 4.00%, the beta (β) for Nagel Equipment is 0.88, and the expected market return is 15.00%. Plugging these numbers into the formula, we get: required return = 4.00% + 0.88 * (15.00% - 4.00%) = 4.00% + 0.88 * 11.00% = 4.00% + 9.68% = 13.68%.

The closest answer to the computed value is (B) 13.55%, which suggests there might be a slight error in the calculation or rounding within the provided answer choices.