8. Changes to the security market line The following graph plots the current sec

Question

8. Changes to the security market line The following graph plots the current security market line (SML) and indicates the return that investors require from holding stock from Happy Corp. (HC). Based on the graph, complete the table that follows. REQUIRED RATE OF RETURN Percent) 20.0 16.0 12.0 Return on HC's Stock 8.0-_ 4.0 0.0 0.5 1.0 1.5 2.0 RISK IBetal CAPM Elements Value Risk-free rate (RF) Market risk premium (RPM) Happy Corp. stock's beta Required rate of return on Happy Corp. stock An analyst believes that inflation is going to increase by 3.0% over the next year, while the market risk premium will be unchanged. The analyst uses the Capital Asset Pricing Model (CAPM). The following graph plots the current SML Calculate Happy Corp.'s new required return. Then, on the graph, use the green points (rectangle symbols) to plot the new SML suggested by this analyst's prediction. Happy Corp.'s new required rate of return is Tool tip: Mouse over the points on the graph to see their coordinates.

Explanation / Answer

Risk free rate (rf) = 2% (blue line (SML) intercept at y axis) Market Risk premium = ß *(Expected market return – risk free rate) Where Expected market return is 8% (the red dotted line intercepting at Y-axis) Risk free rate is 2% And ß = 1 The risk-free rate consists of two elements (1) a real risk-free rate of return (2) the inflation premium Market Risk premium = Expected market return – risk free rate)/Beta =(8%-2%)/1=6% The real risk-free rate does not change, but inflation increases by 3%. If inflation increases but the market risk premium is unchanged, the SML shifts up vertically, and the new SML is parallel to the old SML. Because the risk-free rate is the sum of the real rate of return and the inflation premium, rap increases from 2% to 5% RE=Rf+Beta*(RM-Rf) Where RF= Risk Free Return Beta=Beta of the Happy Corporation RM=Expected Return =5%+1*(6%) 11%

Related Questions

Navigate

• Browse (All)
• Browse 8
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.