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

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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



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