Question

Here are data on two companies. The T-bill rate is 4% and the market risk premium is 6%.

Company	\(1 Discount Store	Everything \)5
Forecast return	12%	11%
Standard deviation of returns	8%	10%
Beta	1.5	1.0

What would be the fair return for each company, according to the capital asset pricing model (CAPM)?

Short answer

The correct answer would be 13% and 10% respectively

Step-by-step solution

Definition

The CAPM gives the relation between risk and return. This means that the higher the risk, higher would be the return on investment.

Calculation of Fair Return of $1 Discount Store

Required Return = Risk free rate + Beta (Market risk premium)

= 0.04 + 1.5 x (0.06)

=0.04 + 0.09

= 0.1300 = 13%

Calculation of Fair Return of Everything $5

Since Required Return = Risk free rate + Beta (Market risk premium)

= 0.04 + 1.0 x (0.06)

=0.04 + 0.06

= 0.1000 = 10%