MGT201 GDB 2 (June 2010)

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Just for Idea


A year ago, you have purchased some stock with beta of 0.6. You have not noticed how well
your stock has done during the year, but you do know what the T-bills rate has remained 10% throughout the year. As you are reading the financial journal, you have noticed that the
market risk premium for average stock is 5% during the year. Given only this information:

a) What do you require the return on your stock?
Referance:
Handouts page 107 Lecture 24
SMl Linera Equation for the required retun of any stock A:
rA=rRF+(rM-rRF)βA
In the above formula
rA= Return that Inverstors Required from Investment in Stock A.
rRF= Risk Free Rate of Return (i.e. T-Bill ROR).
rM= Return that Investor Require from Investment in an Average Stock (or the market

Portfolio of All Stock where βM = +1.0 always).
βA= Beta for stock A. (rM - rRF) βA= Risk Premium or additional return Required in
Excess of Risk Free ROR to compensate the Investor for the Additional Market Risk of the
Stock

a) What fo you require the return on your stock?

rA = rRF + (rM - rRF) beta
rA= ?
rRF = 10%
rM- rRF = 5%
Beta = 0.6
rA = 10% + (5%) 0.6
rA = 10% + 3%
rA = 13%

So Reqiured rate of Return is 13%

Rm - RRF = Market Premium risk.... so it is already given in GDB question no need to do 15 - 10 or 10 - 15



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b) Comment whether you will still hold stock, if the market return is 15%?Reference
Handouts page 111 Lecture 25
SML-Numerical Example:
Calculate the required rate of return for stock A given the following data:
βA=2.0 (i.e. Stock A is Twice as risky as the Market)
rM=20% pa (i.e AMarket ROR or ROR on a portfolio consisting of All Stocks or ROR on
the "Average stock")
rRF=10% pa (i.e. T-Bill ROR)
SML Equation (assumes Efficient Stock Pricing, Risk and Return)
rA=rRF+(rM-rRF)βA
=10%+(20%-10%)(2.0)=30%
Interpretation of Result:
Investors require a 30% pa Return from Investment in Stock A. This is higher than the Market ROR because the Stock (Beta=2.0) is Riskier than the Market (Beta=1.0 always).
If Required Return (30%) is higher than Expected Return (20%) it means that Stock A is Unlikely to Achieve the Investors Requirement and Investors will Not Invest in Stock A