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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

REQUIRED RATE OF RETURN Stock R has a beta of 1.5, Stock S has a beta of 0.75, the required return on an average stock is 13%, and the risk-free rate of return is 7%. By how much does the required return on the riskier stock exceed the required return on the less risky stock?

Summary Introduction

To determine: The difference between the required return on the riskier stock and the less risky stock.

The Required Rate of Return:

The required rate of return is the rate, which should be the 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 stock R, the value of beta is 1.5.

For stock S, the value of beta is 0.75.

The required return on an average stock is 13%.

The risk-free rate of return is 7%.

Calculated,

The required return on stock R is 16%.

The required return on stock S is 11.5%.

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

The difference in both the stock is 4.5% (16%11.5%).

Working note:

Compute the required rate of return for stock R.

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 7% for rRF, 13% for rM, and 1

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