Question

Linke Motors has a beta of 1.30, the T-bill rate is 3.00%, and the T-bond rate is 6.5%. The annual return on the stock market during the past 3 years was 15.00%, but investors expect the annual future stock market return to be 10.00%. Based on the SML, what is the firm's required return? Do not round your intermediate calculations. a. 12.71% b. 10.50% c. 11.05% d. 13.48% e. 10.17%

Answer 1

c. 11.05%

Step-by-step explanation:

The computation of firm's required return is shown below:-

First we need to find out the Market Risk Premium for computing the firm's required return.

Using CAPM, we calculate Market Risk Premium

Expected Future Market Rate of Return = Risk Free Rate on T-Bond + Beta of the Market × Market Risk Premium

10% = 6.5% + 1 × Market Risk Premium

Market Risk Premium = (10% - 6.5%) ÷ 1

= 3.5%

Required Rate of Return = Risk Free Rate + Beta of the Stock × Market Risk Premium

= 6.5% + (1 + 3.00%) × 3.5%

= 6.5% + 1.30 × 3.5%

= 11.05%