1.

Required Rate of Return

Assume that the risk-free rate is 5.5% and that the market risk premium is 7%.
a) What is the required rate of return on a stock with a beta of 1.1? Round your answer to two
decimal places.
Use CAPM Formula
Return of asset = risk free return + beta*expected market return
Return of stock = 5.5% + 1.1*7%
=13.20%

b) What is the required rate of return on a stock with a beta of 2.4? Round your answer to two
decimal places.
5.5% + 2.4*7%
=22.30%

c)

What is the required return on the market? Round your answer to two decimal places.

Market risk premium = return on market risk free rate

Return on market: 7%+5.5%= 12.50%
2. Required Rate of Return
Suppose rRF = 3%, rM = 11%, and rA = 12%.
a.
Calculate Stock A's beta. Round your answer to two decimal places.
12% = 3% + beta*(11%-3%)
Beta=1.125
b.

a.

If Stock A's beta were 1.9, then what would be A's new required rate of return? Round your
answer to two decimal places.
Return on stock = 3% + 1.9*(11%-3%) = 18.20%
3. Required Rate of Return
As an equity analyst you are concerned with what will happen to the required return to Universal
Toddler Industries's stock as market conditions change. Suppose r RF = 8%, rM = 12%, and bUTI = 1.5.
What is rUTI, the required rate of return on UTI Stock? Round your answer to two decimal
places.

Return = 8% + 1.5*(12% - 8%)

=14%
b.

Now suppose rRF increases to 9%. The slope of the SML remains constant. How would this
affect rM and rUTI?
-Select-

I. rM will remain the same and rUTI will increase by 1%.

II. rM will increase by 1% and rUTI will remain the same.
III. Both rM and rUTI will decrease by 1%.
IV.Both rM and rUTI will remain the same.
V. Both rM and rUTI will increase by 1%.
Slope of SML is nothing but the market risk premium. So this means if risk free rate goes up by 1 %
the n market return goes up by 1% to keep constant market premium also return of stock will go up
by 1%
c.

Suppose rRF decreases to 7%. The slope of the SML remains constant. How would this affect
rM and rUTI?
-Select-

I. rM will decrease by 1% and rUTI will remain the same.

II. rM will remain the same and rUTI will decrease by 1%.
III. Both rM and rUTI will increase by 1%.
IV. Both rM and rUTI will remain the same.
V. Both rM and rUTI will decrease by 1%.
Again using the above logic, Slope of SML is nothing but the market risk premium. So this means if
risk free rate goes down by 1 % then market return goes down by 1% to keep constant market
premium also return of stock will go down by 1%

d.

Now assume rRF remains at 8% but rM increases to 14%. The slope of the SML does not remain
constant. How would these changes affect r UTI?
-Select-

I. rUTI will remain the same.

II. rUTI will increase by 3%.
III. rUTI will decrease by 3%.
Return = 8% + 1.5*(14%-8%)= 17%
e.

Assume rRF remains at 8% but rM falls 11%. The slope of the SML does not remain constant.
How would these changes affect rUTI?
-Select-

I. rUTI will remain the same.

II. rUTI will decrease by 1.5%.
III. rUTI will increase by 1.5%.
Return=8% + 1.5*(11%-8%) = 12.5%

4. Portfolio Beta
You have a $2 million portfolio consisting of a $100,000 investment in each of 20 different stocks. The
portfolio has a beta of 0.75. You are considering selling $100,000 worth of one stock with a beta of 0.9
and using the proceeds to purchase another stock with a beta of 1.4. What will the portfolio's new
beta be after these transactions? Do not round intermediate calculations. Round your answer to two
decimal places.
beta after disposal
0.75 = 0.9 X 100,000 + B X 1,900,000 / 2,000,000
B = 0.742
and beta after acquiring
B = 0.742 X 1,900,000 + 1.4 X 100,000 / 2,000,000
Beta = 0.775 is the revised beta after the transaction

5. Required Rate of Return

Stock R has a beta of 1.9, Stock S has a beta of 0.70, the expected rate of return on an average stock
is 9%, and the risk-free rate is 6%. By how much does the required return on the riskier stock exceed
the required return on the riskier stock exceed that on the less risky stock? Round your answer to two
decimal places.
The Required return on stock R = .06 + 1.9(.09-.06) = 0.117=11.7%
The Required return on stock S = .06 + 0.7*(.09-.06) = .16 = .081 = 8.10%
So required return on the riskier stock exceed the required return on the less risky stock by 3.60%
(11.7%-8.1%).