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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

REQUIRED RATE OF RETURN Suppose rRF = 4%, rM = 10%, and bi = 14.

  1. a. What is ri, the required rate of return on Stock i?
  2. b. Now suppose that rRF (1) increases to 5% or (2) decreases to 3%. The slope of the SML remains constant. How would this affect rM and ri?
  3. c. Now assume that rRF remains at 4%, but rM (1) increases to 12% or (2) falls to 9%. The slope of the SML does not remain constant. How would these changes affect ri?

a.

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 earned on an investment to keep that investment running in the market. When the required return is earned, only then the individual investors and the companies invest in that particular investment.

Explanation

Given,

The risk-free rate is 4%.

The market return is 10%.

The value of the stock’s beta is 1.4.

Calculation of the required rate of return:

The formula to calculate the required rate of return is,

ri=rRF+(rMrRF)×bi

Where,

  • ri is the required return on the stock.
  • rRF is the risk-free return.
  • rM is the market return.
  • bi is the value of the stock’s beta
  • b. (1)

Summary Introduction

To determine: The effect on market risk premium and the required return on the stock when the risk-free rate (1) increases to 5%.

  • (2)

Summary Introduction

To determine: The effect on market risk premium and the required return on the stock when the risk-free rate and (2) decreases to 3%.

c. (1)

Summary Introduction

To determine: The effect on the required return of stock if market return (1) increases to 12% and (2) falls to 9%.

(2)

Summary Introduction

To determine: The effect on the required return of stock if market return (2) falls to 9%.

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