Required Return on Plaid Pants' Common Stock

Required Return on Acme's Common Stock

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Question

Plaid Pants, Inc. common stock has a beta of 0.90, while Acme Dynamite Company common stock has a beta of 1.80. The expected return on the market is 10 percent, and the risk-free rate is 6 percent. According to the capital-asset pricing model (CAPM) and making use of the information above, the required return on

Plaid Pants' common stock should be , and the required return on Acme's common stock should be .

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Explanations

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A. B. C. D.

B

The capital asset pricing model (CAPM) is a financial model that calculates the expected return on an investment by considering the risk-free rate, the expected return on the market, and the asset's beta. Beta is a measure of an asset's sensitivity to changes in the market.

The formula for the CAPM is:

Required return = risk-free rate + beta x (expected return on the market - risk-free rate)

Given the information in the question, we can calculate the required return for each stock using the CAPM.

For Plaid Pants, Inc.:

Beta = 0.90 Expected return on the market = 10% Risk-free rate = 6%

Required return = 6% + 0.90 x (10% - 6%) Required return = 6% + 0.90 x 4% Required return = 6% + 3.6% Required return = 9.6%

Therefore, the required return on Plaid Pants' common stock is 9.6%.

For Acme Dynamite Company:

Beta = 1.80 Expected return on the market = 10% Risk-free rate = 6%

Required return = 6% + 1.80 x (10% - 6%) Required return = 6% + 1.80 x 4% Required return = 6% + 7.2% Required return = 13.2%

Therefore, the required return on Acme's common stock is 13.2%.

The correct answer is B. 9.6 percent; 13.2 percent.

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