Question

Assignment 08 - Risk and Rates of Return The following graph plots the current security market line (SML) and indicates the return that investors require from holding stock from Happy Corp. (HC). Based on the graph, complete the table that follows. REQUIRED RATE OF RETURN Percent 20.0 Return on HC's Stock RISK (Betal Value CAPM Elements Risk-free rate (r) Market risk premium (RPM) Happy Corp. stock's beta Required rate of return on Happy Corp. stock 1.1% 2.2% 8.0% 2.096

Answer 1

Based on the graph -

Risk free rate (rRF) = 2% (blue line (SML) intercept at y axis)

Market Risk premium (RPM) = (Expected market return – risk free rate)

Where Expected market return is 8% (the yellow dotted line intercepting at Y-axis)

Therefore

Market Risk premium (RPM) = 8% -2% = 6%

Happy Crop. Stock’s beta = 1.0 (the yellow dotted line intercepting at X-axis)

Required rate of return of Happy Crop = risk free rate (rRF) + β *(Expected market return – risk free rate)

= 2% + 1.0 * (8% - 2%)

= 2% + 1.0 *6% = 8%

Happy Crop’s new required rate of return is 11%

The SML helps determine the level of risk aversion among investors. The steeper the slope of the SML, the higher the level of risk aversion.