Investors expect the market rate of return in the coming year to be 12%. The T-b

Question

Investors expect the market rate of return in the coming year to be 12%. The T-bill rate is 4%. Changing Fortunes Industries' stock has a beta of .5. The market value of its outstanding equity is $100 million.

A. What is your best guess currently as to the expected rate of return on Changing Fortunes' stock? You believe that stock is fairly priced.

B. If the market return in the coming year actually turns out to be 10%, what is your best guess as to the rate of return that will be earned on Changing Fortunes' stock?

C. Suppose now that Changing Fortunes' stock return during the year turns out to be 10%. What is your best guess as to the settlement the market previously expected Changing Fortunes to receive from the lawsuit? (Continue to assume that the market return in the year turned out to be 10%.) The magnitude of the settlement is the only unexpected firm-specific event during the year.

Explanation / Answer

a) if market return is estimated to be 12% and beta 0.5

so expected stock return= 4+0.5*(12-4)=8%

b) if the acutal marker return is 10% the stock return needs to be 7% based on the avg beta value

4+0.5*(10-4)=7%

c) in reality both market return and the stock return is 10% due to some unexpected lawsuit in favour of the company so there is 3% hike from avg 7% which should be the case

so the company should get this 3% from the lawsuit so it should receive $3 million from law suit

due to the market movement the net equity becomes $107million and form lawsuit it gets $3million thus making the net return of 10%

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