The Picante Corp.\'s beta is 0.7. Treasury Bills yield 5% and an average stock y

Question

The Picante Corp.'s beta is 0.7. Treasury Bills yield 5% and an average stock yields 10%.

a. Write and sketch the SML and locate Picante on it. Calculate Picante's required rate of return and show it on the graph.

b. Assume the yield on Treasury Bills suddenly increases to 7% with no other changes in the financial environment. Write and sketch the new SML, calculate Picante's new required rate, and show it on the new line.

c. Now assume that besides the change in part (b), investor's risk aversion increases so that the market risk premium is 7%. Write and sketch the resulting SML, calculate Picante's required return, and show it on the last line.

Explanation / Answer

kX = kRF + (kM - kRF) bX

            kX = 5 + (10 - 5) bX

            kX = 5 + 5bX

To determine the SML, calculate kX for bX=0 and bX=1.0 when bX = 0, kX = 5%, and when bX = 1.0, kX = 10%

For Picante:     kX = 5 + 5(.7)

                             = 8.5%

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b.     

            kX = kRF + (kM - kRF) bX

            kX = 7 + (12 - 7) bX

            kX = 7 + 5bX

When bX = 0, kX = 7%, and when bX = 1.0, kX = 12%

For Picante:     kX = 7 + 5(.7)

                             = 10.5%

======================

c.

kX = kRF + (kM - kRF) bX

            kX = 7 + 7bX

When bX = 0, kX = 7%, and when bX = 1.0, kX = 14%.

For Picante:     kX = 7 + 7(.7)

                           = 11.9%

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