Question

Company A has a beta of 0.70, while Company B's beta is 1.20. The required return on the stock market is 11.00%, and the risk-free rate is 4.25%. What is the difference between A's and B's required rates of return?

A) 2.75%
B) 2.89%
C) 3.05%
D) 3.38%

Answer 1

The difference between Company A's and Company B's required rates of return can be calculated using the Capital Asset Pricing Model (CAPM).

Step-by-step explanation:

The difference between Company A's and Company B's required rates of return can be calculated using the Capital Asset Pricing Model (CAPM). The CAPM formula is:

R(a) = R(f) + beta * (R(m) - R(f))

Where:

R(a) is the required rate of return,

R(f) is the risk-free rate,

beta is the measure of a stock's risk relative to the overall market,

R(m) is the return on the stock market.

For Company A,

R(a) = 4.25% + 0.70 * (11.00% - 4.25%) = 4.25% + 0.70 * 6.75%

R(a) = 4.25% + 4.725%

R(a) = 8.975%

For Company B,

R(a) = 4.25% + 1.20 * (11.00% - 4.25%) = 4.25% + 1.20 * 6.75%

R(a) = 4.25% + 8.10%

R(a) = 12.35%

The difference between A's and B's required rates of return is 12.35% - 8.975% = 3.375%, which is approximately 3.38% (option D).