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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 Stock R has a beta of 2.0, Stock s has a beta of 0.45, the required return on an average stock is 10%, and the risk-free rate of return is 5%. 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 risky stock and the less risky stock.

Introduction:

The Required Rate of Return:

The required rate of return is the rate which should be the minimum earning 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 2.

For Stock S, the value of beta is 0.45.

The required return on an average stock is 10%.

The risk-free rate of return is 5%.

Calculated (working note),

The required return on Stock R is 15%.

The required return on Stock S is 7.25%.

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

Formula to calculate difference between required return on Stock R and S,

Difference in return=Return of stock RReturn of stock S

Substitute 15% for return of stock R, and 7.25% for return of stock S

Difference in return=15%7.25%=7.75%

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 5% for rRF , 10% for rM , and 2 for bstock in equation (I)

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