Question

Company A has a beta of 0.70, while Company B's beta is 0.85. The required return on the stock market is 11.00%, and the risk-free rate is 2.25%. What is the difference between A's and B's required rates of return? (Hint: First find the market risk premium, then find the required returns on the stocks.)

Answer 1

Market risk premium = Market return - Risk-free rate = 11.00% - 2.25% = 8.75%

Required return A = r_RF + b_A(RP_M) = 2.25% + 0.70(8.75%) = 8.38%

Required return B = r_RF + b_B(RP_M) =  2.25% + 0.85(8.75%) = 9.69%

Difference between A's and B's required rates of return = 9.69% - 8.38% = 1.31%