The following graph plots the current security market line S

The following graph plots the current security market line (SML) and indicates the return that investors require from holding stock from Happy Corp. (HC). Based on the graph, complete the table that follows. REQUIRED RATE OF RETURN (Percent 20.0 16.0 12.0 Return on HC\'s Stock 8.0 4,0 ? 0.0 0.5 1.0 1.5 RISK (Betal CAPM Elements Value Risk-free rate (RF) Market risk premium (RPM) Happy Corp. stock\'s beta Required rate of return on Happy Corp. stock 4.0% I 78% 0.6 5%

Solution

stock required return = risk free rate + beta * market risk premium

= 4% + 0.6 * 7.8% = 4% + 4.68% = 8.68%

Accounting for inflation, new required return

= (1 + 8.68%) * (1 + 2%) - 1 = 10.85%

With increasing level of risk aversion, slope of SML would be flattish

COrrect choice A