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Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250
Textbook Problem

CAPM AND REQUIRED RETURN Calculate the required rate of return for Mudd Enterprises assuming that investors expect a 3.6% rate of inflation in the future. The real risk-free rate is 1.0%, and the market risk premium is 6.0%. Mudd has a beta of l.5, and its realized rate of return has averaged 8.5% over the past 5 years.

Summary Introduction

To determine: The required rate of 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,

The rate of inflation for future is 3.6%.

The real risk-free rate is 1%.

The market risk premium is 6%.

The value of stock’s beta is 1.5.

The realized average rate of return is 8.5% over past 5 years.

Calculated,

The risk-free rate of return is 4.6% (working note).

Compute the required rate of return on the stock.

The formula to calculate the required rate of return is,

rR stock=rRF+(rMrRF)×bR stock

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 4.6% for rRF , 6% for rM , and 1

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