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    CAPM, Bonds

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    1. Calculate the required rate of return for Mercury Inc., assuming that investors expect 5% rate of inflation in the future. The real risk-free rate is equal to 3% and the market risk premium is 5%. Mercury has a beta of 2.0, and its realized rate of return has averaged 15% over the last 5 years.

    2. A stock has an expected return of 12.25%. The beta of the stock is 1.15 and the risk-free rate is 5%. What is the market risk premium?

    3. An annual coupon bond with a $1,000 face value matures in 10 years. The bond currently sells for $903.7351 and has a 9% yield to maturity. What is the bond's annual coupon rate?

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    Solution Preview

    1.  Calculate the required rate of return for Mercury Inc., assuming that investors expect 5% rate of inflation in the future.  The real risk-free rate is equal to 3% and the market risk premium is 5%.  Mercury has a beta of 2.0, and its realized rate of return has averaged 15% over the last 5 years.

    risk free rate = real risk free rate + inflation =3% + 5% = 8%
    (r m - r f) = market risk premium= 5%
    Therefore r m = 13% =8%+5%

    CAPM (Capital Asset Pricing Model equation is:
    r A= r f + βA (r m - r f)

    risk free rate= r f = 8%
    beta ...

    Solution Summary

    Answers 3 questions:
    1) Calculates the required rate of return for Mercury Inc. using CAPM.
    2) Calculates market risk premium using CAPM.
    3) Calculates bond's annual coupon rate given price and yield to maturity.

    $2.19

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