Suppose you are given the following information. ?e beta of company i, bi, is 1.

Question

Suppose you are given the following information. ?e beta of company i, bi, is 1.1, the risk-free rate, rRF, is 7%, and the expected market premium, rM - rRF, is 6.5%. (Assume that ai - 0.0). Because your company is smaller than average and more successful than average (that is, it has a low book-to-market ratio), you think the Fama-French three-factor model might be more appropriate than the CAPM. You estimate the additional coefficients from the Fama-French three- factor model: ?e coefficient for the size effect, ci, is 0.7, and the coefficient for the book-to-market effect, di, is -0.3. If the expected value of the size factor is 5%, and the expected value of the book- to-market factor is 4%, what is the required return using the Fama-French three-factor model?

Explanation / Answer

beta= 1.1 Rf= 7% MRP= 6.5% R= {7+(1.1x6.5)}= 14.15%

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