Question

XYZ common stock has a beta of 0.50, while ABC common stock has a beta of 2.0. The expected return on the market is 12%, and the risk-free rate is 4%. Based on the CAPM, the required returns on XYZ and ABC common stock are closest to:

a) 4%; 16%
b) 6%; 24%
c) 8%; 20%
d) 10%; 28%

Answer 1

The required returns on XYZ and ABC common stock, based on the CAPM, are 8% and 20%, respectively. The formula for CAPM combines the risk-free rate, the beta of the stock, and the market's expected return to find the required return.

Step-by-step explanation:

To determine the required returns on XYZ and ABC common stock using the CAPM (Capital Asset Pricing Model), we can use the formula:

Required Return = Risk-Free Rate + Beta * (Expected Market Return - Risk-Free Rate)

For XYZ:

• Beta: 0.50
• Risk-Free Rate: 4%
• Expected Market Return: 12%

Required Return = 4% + 0.50 * (12% - 4%) = 4% + 0.50 * 8% = 4% + 4% = 8%

For ABC:

• Beta: 2.0
• Risk-Free Rate: 4%
• Expected Market Return: 12%

Required Return = 4% + 2.0 * (12% - 4%) = 4% + 2.0 * 8% = 4% + 16% = 20%

Therefore, the answer is c) 8%; 20%.