Question

A stock has a required return of 9%, the risk-free rate is 4.5%, and the market risk premium is 3%.

a. What is the stock’s beta?
b. If the market risk premium increased to 5%, what would happen to the stock’s required rate of return?
Assume that the risk-free rate and the beta remain unchanged.

Answer 1

a.

The beta of the stock is 1.5

b.

r = 0.12 or 12%

The stock's required rate of return (r) will increase to 12%.

Step-by-step explanation:

The required rate of return or cost of equity is the minimum return that investors expect/require to invest in a stock of a company. The required rate of return on a company's stock can be calculated using the CAPM equation.

The formula for required rate of return (r) under this model is,

r = rRF + Beta * rpM

Where,

• rRF is the risk free rate
• rpM is the market risk premium

a.

0.09 = 0.045 + Beta * 0.03

0.09 - 0.045 = Beta * 0.03

0.045 / 0.03 = Beta

Beta = 1.5

b.

New rpM = 0.05

r = 0.045 + 1.5 * 0.05

r = 0.12 or 12%

The stock's required rate of return (r) will increase to 12%