A stock has a beta of 1.25, the expected return on the market is 11.7 percent, and the risk-free...

Question:

A stock has a beta of 1.25, the expected return on the market is 11.7 percent, and the risk-free rate is 4.5 percent.

What must the expected return on this stock be? Do not round immediate calculations and enter two answer as a percent rounded to 2 decimal places.

Expected return by capital asset pricing model(CAPM):

Expected return is the return expected by the investors on particular investment. In general, Investors have many options to invest their money. some of them are fixed deposits, Treasury bills, corporate bonds on low risk and Equity, direct investment in a business, derivatives on high risk.

For low risk investment options, the return is also low(near to or equal to risk free rate).

For high risk investment options, the return is also high(risk free rate + risk premium for taking high risk)

CAPM is the model to calculate the required return on equity investments. The components of CAPM are risk free rate, beta of the company and the market return.

Using CAPM:

{eq}Return\ on\ equity(Re) = Risk\ free\ rate(Rf) + \beta(Market\ return(Rm) - Risk\ free\ rate(Rf)) {/eq}

Answer and Explanation:

Given,

Beta of the company = 1.25

Market return(Rm) = 11.7%

Risk free rate(Rf) = 4.5%

Using CAPM:

{eq}Expected\ return(Re) = Risk\ free\ rate(Rf)...

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Capital Asset Pricing Model (CAPM): Definition, Formula, Advantages & Example

from Financial Accounting: Help and Review

Chapter 15 / Lesson 6
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