Porter Plumbings stock had a required return of 1025 last ye

Porter Plumbing\'s stock had a required return of 10.25% last year, when the risk-free rate was 5.50% and the market risk premium was 4.75%. Then an increase in investor risk aversion caused the market risk premium to rise by 2%. The risk-free rate and the firm\'s beta remain unchanged. What is the company\'s new required rate of return?

Solution

As per Capital Asset pricing Model:

E(R) = Rf +Beta * ( Rm - Rf )

Where

E(R) = Expected rate of return = 10.25%

Rf = Risk free rate = 5.50%

(Rm - Rf) = Risk premium = 4.75%

From this, we need to caluculate Beta

10.25% = 5.50% + Beta * (4.75%)

Beta = 1

Next,we need to caluculate new required rate of return,

For this,

(Rm - Rf)  = Risk premium = 6.75% i.e (4.75%+2)

Now

Required rate of return = 5.50% + 1 * ( 6.75% )

Required rate of return = 12.25%