Suppose risk free rate is 9%, return on the market is 14%, and beta for Firm A i

Question

Suppose risk free rate is 9%, return on the market is 14%, and beta for Firm A is 1.3. Suppose that the risk free rate decreases to 8%, and the slope of the Securities Market Line remains constant, how would this affect return on the market and required return on Firm A's stock? O Return on the market is now 13%; return on Firm A's stock is 14.5% Return on the market is now 14%, return on Firm A's stock is 15.5% O Return on the market is now 12%; return on Firm A's stock is 14.5% O Return on the market is now 11.5%; return on Firm A's stock is 12.8% Return on the market is now 15%; return on Firm A's stock is 16.5%

Explanation / Answer

Correct option is > Return on market is now 13%; return on firm A’s stock is 14.50%

As market risk premium = Slop of SML; Slop is same hence we will have no change in Market risk premium because the as risk free rate decreases by 1% or to 8% the market return also falls by 1% or say 13%

New expected return on stock = Risk free rate + Beta x (Market return – Risk free rate)

= 8% + 1.3 x (13%-8%) = 14.5%

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