A firm has a beta of 1.5. The risk-free rate is 4% and the return on the market is 12%. The standard deviation is 14%.According to the Capital Asset Pricing Model (CAPM), the stock should earn:4%8%12%16%None of the above
Question
A firm has a beta of 1.5. The risk-free rate is 4% and the return on the market is 12%. The standard deviation is 14%.According to the Capital Asset Pricing Model (CAPM), the stock should earn:4%8%12%16%None of the above
Solution
The Capital Asset Pricing Model (CAPM) is used to calculate the expected return on an investment given its risk relative to the market. The formula for CAPM is:
Expected Return = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate)
Given the values in the question:
Risk-Free Rate = 4% Beta = 1.5 Market Return = 12%
We can substitute these values into the formula:
Expected Return = 4% + 1.5 * (12% - 4%)
Solving this gives:
Expected Return = 4% + 1.5 * 8% Expected Return = 4% + 12% Expected Return = 16%
So, according to the Capital Asset Pricing Model (CAPM), the stock should earn 16%.
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