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Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977
Textbook Problem

CAPM AND REQUIRED RETURN Bradford Manufacturing Company has a beta of 1.45, while Farley Industries has a beta of 0.85. The required return on an index fund that holds the entire stock market is 12.0%. The risk-free rate of interest is 5%. By how much does Bradford’s required return exceed Farley’s required return?

Summary Introduction

To determine: The difference between the required return.

The Required Rate of Return:

The required rate of return is the rate, which should be minimum 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 1.45.

For Company F, the value of beta is 0.85.

The required return on the entire stock market is 12%.

The risk-free rate of interest is 5%.

Calculated,

The required return on Company B is 15.15%.

The required return on Company F is 10.95% (refer working note).

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

The difference in both the stock is 4.2% (15.15%10.95%).

Working note:

Compute the required rate of return for stock of Company B.

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.

Substitute 5% for rRF, 12% for rM, and 1

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