Question

Parkway corporation has a beta of 1.5 and is currently in equilibrium. The required rate of return on the stock is 12.0% versus a required return on an average stock, rm, is 10.0%. Now the required return on an average stock, rm, increases by 45.0% (not percentage points) to 14.5%. Neither betas nor the risk-free rate change. What would parkway's new required return be? (hint: first find the risk-free rate, rrf. do not round your intermediate calculations).

a) 13.25%
b) 13.75%
c) 14.25%
d) 14.75%
e) 15.25%
f) 15.75%
g) 16.25%

Answer 1

To find Parkway's new required return after an increase in the required return on an average stock, we calculate the risk-free rate using the initial information provided and then apply the Capital Asset Pricing Model with the updated average stock return, resulting in a new required return of 19.75%.

Step-by-step explanation:

The required rate of return on Parkway Corporation's stock, which has a beta of 1.5, needs to be recalculated given that the required return on an average stock, rm, has increased by 45% from 10.0% to 14.5%. To find Parkway's new required return, we first need to determine the current risk-free rate (rrf) using the Capital Asset Pricing Model (CAPM).

Using CAPM, the existing required return can be written as: 12.0% = rrf + (1.5 × (10.0% - rrf)). By solving for rrf, we find that rrf = 4.0%. Now, with the new rm of 14.5%, we can calculate the new required return: New required return = 4.0% + (1.5 × (14.5% - 4.0%)) which equals 19.75%. Therefore, the correct answer is not listed among the options provided.