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Question

af/servlet/quiz?quiz action-takeQuiz&quiz; probGuid QNAPCOA801010000003e43f3200b0000&ctx; brown1-0012&ck; 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 200 16.0 Return on HC's Stock 120 L0 0.0 S1.0 1.5 2.0 RISK IBetal CAPM Elements Value Rusk-free rate (rr) Market risk premium ) Happy Corp. stock's beta Required rate of return on Happy Corp. stock An analyst believes that inflation is going to increase by 20% over the next year, while the market na 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

Explanation / Answer

From the graph following information can be obtained:

Risk free rate = 5%

Market Risk premium = 9%-5% = 4%

Stock’s beta = 1.25

Required return on stock can be calculated using the following formula:

Required Return = Rf + Beta x MRP

                                = 5% + 1.25 x 4%

                                = 10%

New required rate after incorporating inflation = inflation rate + Rf + Beta x MRP

                                                                                            = 2%+5% + 1.25 x 4%

                                                                                          = 12%

High beta stocks are most affected by changes in risk aversion.

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