A year ago, you have purchased
some stock with beta of 0.6. You have not noticed how well your stock has done
during the year, but you do know that the T-bills rate has remained 10%
throughout the year. As you are reading the financial journal, you have noticed
that the market risk premium for average stocks is 5 % during the year. Given
only this information:
a)
What do you require the return on
your stock?
b)
Comment whether you will still
hold the stock, if the market return is 15%?
Suggested Solution
(Q1)
Formula For ROR
ROR = Ks = Krf+B*(Km-Krf)
Where Ks=Required Rate of Return
Krf = Risk Free rate (Here T Bills are
considered Risk Free)
B = Beta
(0.6)
Km = Expected market Rate of return of
overall stocks
Risk Premium = (Km-Krf)=5%
Or you may also interpret it as
Km = Risk Premium+risk Free
Km = 0.05+0.1 = 0.15
Now
Risk Premium = (Km-Krf) = 0.15-0.1 = 0.05
Note But risk premium is given 5 % So take it
Directly in (km-Krf) Because if will not
take it directly calculation will difficult so make it simple and easy
Now
Ks = Krf+B*(Km-Krf)
Ks = 0.1+0.6*(0.05) = 0.1+0.03 = 13%
So it has been proved that ROR is
13 %
(Q2)
In my point of view The Market rate
return on stock is 15% and Required Rate of Return on Stock is 13% so Market
Rate of Return is greater than Required Rate of Return So I will Not hold The
stock. Because I receive 2% extra than my requirement and there are also
possibilities that in future (Long Run) high risk is always involved so The
Stock value may fall in the future.