   Chapter 8, Problem 4P 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

EXPECTED AND REQUIRED RATES OF RETURN Assume that the risk-free rate is 5% and the market risk premium is 6%. What is the required return for the overall stock market? What is the required rate of return on a stock with a beta of 1.2?

Summary Introduction

To determine:

The required rate of return for overall stock market and for the given beta value.

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 risk-free rate is 5%.

The return on market premium is 6%.

The value of the beta stock is 1.2.

Assumed,

The value of the beta for the overall market is considered as 1.

Compute the required rate of return for overall market.

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 5% for rRF, 6% for rM, and 1 for bstock.

rstock=5%+(6%5%)×1=5%+1%=6%

The required return on the stock for the overall market is 6%

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