What is the stock’s required rate of return according to CAPM?
Question:
a.What is the stock’s required rate of return according to CAPM?
b.What is the stock’s present market price per share, assuming this required return?
c.What would be the required rate of return and market price per share if the beta were 0.50? (Assume that the other things stay the same.)
d.Explain the change in required rate of return and market price per share in part .C?
Answer:
a) required rate of return = risk free rate + beta (expected market return - risk free rate)
= 0.075 + 2 (0.15 - 0.075)
= 0.225 or 22.5%
b) price = dividend (one + growth rate) / required rate of return - growth rate
= $4.00 (1.10) / 0.225 - 0.10
= $4.40 / 0.125
= $35.20
c) required rate of return = 0.075 + 0.50 (0.15 - 0.075)
= 0.1125 or 11.25%
price = $4.00 (1.10) / 0.1125 - 0.10
= $4.40 / 0.0125
= $352.00
d) The required rate of return changed because beta changed. In the first example, beta was 2, which indicates a very risky stock and therefore stockholders would expect a higher required rate of return. In the second example, beta was 0.5, which indicates a low risk stock and therefore stockholders would expect a lower required rate of return. If investors require a lower rate of return, then they are willing to pay a higher price for the stock. That is why when the required rate of return went down from 22.5% to 11.25%, the price of the stock drastically increased. The same would hold true if the required rate of return was higher. The investors would then be willing to pay a lower price for the stock.
Hope that is all correct :)
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