Question

Porter Plumbing's stock had a required return of 11.75% last year, when the risk-free rate was 5.50% and the market risk premium was 4.75%. Then an increase in investor risk aversion caused the market risk premium to rise by 2%. The risk-free rate and the firm's beta remain unchanged. What is the company's new required rate of return? (Hint: First calculate the beta, then find the required return.)a. 14.38%b. 14.74%c. 15.11%d. 15.49%e. 15.87%

Answer 1

Answer:

Option (a) is correct.

Explanation:

E(r) = Rf + B (Rm - Rf)

where ,

E(r) = Expected return

Rf = risk free rate

B = Beta

Rm = Market Return

Rm = Rf is Market risk premium

11.75% = 5.5% + B (4.75%)

11.75% - 5.5% = B × 4.75%

6.25% ÷ 4.75%= B

B = 1.3157

New required rate of return = Rf + B (Rm - Rf)  

                                               = 5.5% + 1.3157 × (4.75% + 2%)

                                               = 5.5% + 1.3157 × 6.75%

                                                = 5.5% + 0.0888

                                                = 0.1438 or 14.38%