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Required Rate of Return

As an equity analyst you are concerned with what will happen to the required return to Universal Toddler Industries's stock as market conditions change. Suppose rRF = 5%, rM = 9%, and bUTI = 1.7.
What is rUTI, the required rate of return on UTI Stock? Round your answer to two decimal places.
%

Now suppose rRF increases to 6%. The slope of the SML remains constant. How would this affect rM and rUTI?

I. rM will remain the same and rUTI will increase by 1%.
II. rM will increase by 1% and rUTI will remain the same.
III. Both rM and rUTI will decrease by 1%.
IV.Both rM and rUTI will remain the same.
V. Both rM and rUTI will increase by 1%.

Suppose rRF decreases to 4%. The slope of the SML remains constant. How would this affect rM and rUTI?

I. Both rM and rUTI will remain the same.
II. Both rM and rUTI will decrease by 1%.
III. rM will decrease by 1% and rUTI will remain the same.
IV. rM will remain the same and rUTI will decrease by 1%.
V. Both rM and rUTI will increase by 1%.

Now assume rRF remains at 5% but rM increases to 11%. The slope of the SML does not remain constant. How would these changes affect rUTI?

I. rUTI will increase by 3.4%.
II. rUTI will remain the same.
III. rUTI will decrease by 3.4%.

Assume rRF remains at 5% but rM falls 8%. The slope of the SML does not remain constant. How would these changes affect rUTI?

I. rUTI will increase by 1.7%.
II. rUTI will remain the same.
III. rUTI will decrease by 1.7%.

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The following helps with various problems involved the required rate of return.

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Solution:
rRF = 5%, rM = 9%, and bUTI = 1.7. 
a. Required return = Risk free rate + Beta * [Market return - Risk free rate]
.05 + 1.7 * [.09 - .05]
11.8%

b. Now suppose rRF increases to 6%. The slope of the SML remains constant. How would this affect rM and rUTI? 
When Risk free rate increases to 6% and when slope of SML remains constant, the return on market will also ...

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Radhika Lakshmi, MPhil
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  • MCom, Annamalai University
  • IATA, International Air Transport Association
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