Mgt201 GDB Solution
Monday, January 03, 2011 Posted In MGT Edit This“Discussion Question”
Given a risk-free rate of 8 percent and a market risk premium of 9.5 percent, based on the betas given in the following table:
Security Beta
A 0.95
B 1.25
1. Calculate required rate of return of each stock?
2. If Ahmed is a risk lover investor, he will prefer to invest in which stock?
3. As against it, Shahzad is a risk averse investor; he will prefer to invest in which stock?
..............
Solution:
Required rate of return for A
Rce = rRF + (rM – rRF) (beta)
Rce = 0.08 + (0.095 – 0.08)(0.95)
Rce = 0.08+(0.015)(0.95)
Rce = 0.08 + 0.01425
Rce = 0.09425 *100
Rce = 9.425%
Required rate of return for B
Rce = rRF + (rM – rRF) (beta)
Rce = 0.08 + (0.095 – 0.08)(1.25)
Rce = 0.08+(0.015)(1.25)
Rce = 0.08 + 0.01875
Rce = 0.09875 *100
Rce = 9.875%
Rce = rRF + (rM – rRF) (beta)
Rce = 0.08 + (0.095 – 0.08)(0.95)
Rce = 0.08+(0.015)(0.95)
Rce = 0.08 + 0.01425
Rce = 0.09425 *100
Rce = 9.425%
Required rate of return for B
Rce = rRF + (rM – rRF) (beta)
Rce = 0.08 + (0.095 – 0.08)(1.25)
Rce = 0.08+(0.015)(1.25)
Rce = 0.08 + 0.01875
Rce = 0.09875 *100
Rce = 9.875%
.........
Market Premium is nothing but a kind of reward which is offered by the market for taking extra risk in the market for the participant. Market Premium is a difference of Expected Market Return and Risk-Free Rate .
Market Premium = Expected Market Return - Risk-Free Rate
Question#1 Answer
Required rate of return for A
Rce = rRF + (rM – rRF) (beta)
Rce = 0.08 + (0.095)(0.95)
Rce = 0.08+0.09025
Rce = 0.17025x100
Rce = 17.025%
Required rate of return for B
Rce = rRF + (rM – rRF) (beta)
Rce = 0.08 + (0.095)(1.25)
Rce = 0.08+0.11875
Rce = 0.19875x100
Rce = 19.875%
Q 2. Ahamad will invest in Stock B
Q.3 Shahzad will invest in Stock A
...............................
Solution 1:
Formula for ROR in CAPM is :
ROR = rRF + (rM – rRF) (beta)
In the case of stock ‘ A’
ROR = 0.08 + (0.095 – 0.08)(0.95)
ROR = 0.08+(0.015)(0.95)
ROR = 0.08 + 0.01425
ROR = 0.09425 *100
ROR = 9.425% Answer
In the case of stock ‘ B’
ROR = 0.08 + (0.095 – 0.08)(1.25)
ROR = 0.08+(0.015)(1.25)
ROR = 0.08 + 0.01875
ROR = 0.09875 *100
ROR = 9.875% Answer
Solution 2:
As Ahmad is a risk lover person he will prefer stock ‘B’ because it has higher beta i.e. 1.25 thus a higher risk.
Solution 3:
Although stock ‘B’ has a better ROR but being a risk averse person Shahzad will prefer Stock ‘A’ because it has lower beta rate thus a lower risk.
...........................
Market Premium is nothing but a kind of reward which is offered by the market for taking extra risk in the market for the participant. Market Premium is a difference of Expected Market Return and Risk-Free Rate .
Market Premium = Expected Market Return - Risk-Free Rate
Question#1 Answer
Required rate of return for A
Rce = rRF + (rM – rRF) (beta)
Rce = 0.08 + (0.095)(0.95)
Rce = 0.08+0.09025
Rce = 0.17025x100
Rce = 17.025%
Required rate of return for B
Rce = rRF + (rM – rRF) (beta)
Rce = 0.08 + (0.095)(1.25)
Rce = 0.08+0.11875
Rce = 0.19875x100
Rce = 19.875%
Q 2. Ahamad will invest in Stock B
Q.3 Shahzad will invest in Stock A
...............................
Solution 1:
Formula for ROR in CAPM is :
ROR = rRF + (rM – rRF) (beta)
In the case of stock ‘ A’
ROR = 0.08 + (0.095 – 0.08)(0.95)
ROR = 0.08+(0.015)(0.95)
ROR = 0.08 + 0.01425
ROR = 0.09425 *100
ROR = 9.425% Answer
In the case of stock ‘ B’
ROR = 0.08 + (0.095 – 0.08)(1.25)
ROR = 0.08+(0.015)(1.25)
ROR = 0.08 + 0.01875
ROR = 0.09875 *100
ROR = 9.875% Answer
Solution 2:
As Ahmad is a risk lover person he will prefer stock ‘B’ because it has higher beta i.e. 1.25 thus a higher risk.
Solution 3:
Although stock ‘B’ has a better ROR but being a risk averse person Shahzad will prefer Stock ‘A’ because it has lower beta rate thus a lower risk.
...........................
A risk loving person will buy if OR > 1 or = 1, but he might also buy when OR is < 1.
The degree of risk aversion increases as your income level falls, due to diminishing marginal
utility of income.
As Ahmad is Risk Lover he will like to invest in Stock B because it has Beta More Than 1 as 1.25
The degree of risk aversion increases as your income level falls, due to diminishing marginal
utility of income.
As Ahmad is Risk Lover he will like to invest in Stock B because it has Beta More Than 1 as 1.25
..........
A risk averse person will not buy if OR < 1. He will also not buy if OR = 1. He might also not
decide to buy if OR > 1.
As Shahzad is risk averse so he will invest in Stock A because it has Beta Less Than 1 as 0.95
decide to buy if OR > 1.
As Shahzad is risk averse so he will invest in Stock A because it has Beta Less Than 1 as 0.95
..........
Semester "Fall 2010"
"Financial Management (MGT201)"
This is to inform that Graded Discussion Board (GDB) has opened according to the following schedule
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January 03, 2011 At 12:01 A.M. (Mid-Night)
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"Capital Asset Pricing Model (CAPM)"
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