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Fundamentals of Financial Manageme...

9th Edition
Eugene F. Brigham + 1 other
ISBN: 9781305635937

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

9th Edition
Eugene F. Brigham + 1 other
ISBN: 9781305635937
Textbook Problem
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CAPM AND REQUIRED RETURN Beale Manufacturing Company has a beta of 1.1, and Foley Industries has a beta of 0.30. The required return on an index fund that holds the entire stock market is 11%. The risk-free rate of interest is 45%. By how much does Beale’s required return exceed Foley’s required return?

Summary Introduction

To determine: The difference between the required return.

Introduction:

The Required Rate of Return:

The required rate of return is the rate which should be the minimum amount need to be earned on an investment to keep that investment running in the market. When the required return is earned only then the users and the companies invest in that particular investment.

Explanation

Given,

For Company B, the value of beta is 1.1.

For Company F, the value of beta is 0.30.

The required return on the entire stock market is 11%.

The risk-free rate of interest is 4.5%.

Calculated (working note),

The required return on Company B is 11.65%.

The required return on Company F is 6.45%.

Compute the difference in both the required rate of return on the stock.

Formula to calculate difference between required return on stock B and F,

Difference in return=Return of stock BReturn of stock F

Substitute 11.65% for return of stock B, and 6.45% for return of stock F

Difference in return=11.65%6.45%=5.20%

Working note:

Required return on stock:

The formula to calculate the required rate of return is,

rstock=rRF+(rMrRF)×bstock (I)

Where,

  • rstock is the required return on the stock.
  • rRF is the risk-free return.
  • rM is the market risk premium.
  • bstock is the value of the stock’s beta.

Compute the required rate of return for stock of Company B

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