A stock has a required return of 9%; the risk-free rate is 2.5%; and the market

Question

A stock has a required return of 9%; the risk-free rate is 2.5%; and the market risk premium is 5%. The stock's beta is 1.3.

A.) If the market risk premium increased to 9%, what would happen to the stock's required rate of return? Assume the risk-free rate and the beta remain unchanged. Pick one:

I. If the stock's beta is greater than 1.0, then the change in required rate of return will be greater than the change in the market risk premium.

II. If the stock's beta is less than 1.0, then the change in required rate of return will be greater than the change in the market risk premium.

III. If the stock's beta is greater than 1.0, then the change in required rate of return will be less than the change in the market risk premium.

IV. If the stock's beta is equal to 1.0, then the change in required rate of return will be greater than the change in the market risk premium.

V. If the stock's beta is equal to 1.0, then the change in required rate of return will be less than the change in the market risk premium.

B.) What is the new stock's required rate of return?

Explanation / Answer

A)  I. If the stock's beta is greater than 1.0, then the change in required rate of return will be greater than the change in the market risk premium.

B) Ke= Rf+beta(Rm-Rf)

or Ke= Rf+beta x risk premium

therefore the new Ke= 2.5+(1.3x9)

Ke= 14.2%

new stock's required rate of return= 14.2%

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