   Chapter 8, Problem 11P Fundamentals of Financial Manageme...

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

Solutions

Chapter
Section Fundamentals of Financial Manageme...

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

CAPM AND REQUIRED RETURN Calculate the required rate of return for Manning Enterprises assuming that investors expect a 3.5% rate of inflation in the future. The real risk-free rate is 2.5%, and the market risk premium is 6.5%. Manning has a beta of 1.7, and its realized rate of return has averaged 13.5% over the past 5 years.

Summary Introduction

To determine: The required rate of 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,

The rate of inflation for future is 3.5%.

The real risk-free rate is 2.5%.

The market risk premium is 6.5%.

The value of stock’s beta is 1.7.

The risk-free rate of interest is 5%.

The realized average rate of return is 13.5% over past 5 years.

Calculated,

The risk-free rate of return is 6% (refer working note).

Compute the required rate of return on the stock.

The formula to calculate the required rate of return is,

rstock=rRF+(rMrRF)×bstock

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 6% for rRF, 6

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