The security market line (SML) is an equation that shows the relationship between risk as measured by beta and the required rates of return on individual securities. The SML equation is given below: Required return on Stock = Risk-free return + (Market risk premium) (Stock's beta) If a stock's expected return plots on or above the SML, then the stock's return is sufficient to compensate the investor for risk. If a stock's expected return plots below the SML, the stock's return Sinsufficient to compensate the investor for risk. The SML line can change due to expected inflation and risk aversion. If inflation changes, then the SML plotted on a graph will shift up or down parallel to the old SML. If risk aversion changes, then the SML plotted on a graph will rotate up or down becoming more or less steep if investors become more or less risk averse. A firm can influence market risk (hence its beta coefficient) through changes in the composition of its assets and through changes in the amount of debt it uses. Quantitative Problem: You are given the following information for Wine and Cork Enterprises (WCE): RF 4%; TM = 7%; RPM = 3%, and beta = 1.2 What is WCE's required rate of return? Do not round intermediate calculations. Round your answer to two decimal places. % If inflation increases by 1% but there is no change in investors' risk aversion, what is WCE's required rate of return now? Do not round intermediate calculations. Round your answer to two decimal places. % Assume now that there is no change in inflation, but risk aversion increases by 2%. What is WCE's required rate of return now? Do not round intermediate calculations. Round your answer to two decimal places. % If inflation increases by 1% and risk aversion increases by 2%, what is WCE's required rate of return now? Do not round intermediate calculations. Round your answer to two decimal places. %
The security market line (SML) is an equation that shows the relationship between risk as measured by beta and the required rates of return on individual securities. The SML equation is given below: Required return on Stock = Risk-free return + (Market risk premium) (Stock's beta) If a stock's expected return plots on or above the SML, then the stock's return is sufficient to compensate the investor for risk. If a stock's expected return plots below the SML, the stock's return Sinsufficient to compensate the investor for risk. The SML line can change due to expected inflation and risk aversion. If inflation changes, then the SML plotted on a graph will shift up or down parallel to the old SML. If risk aversion changes, then the SML plotted on a graph will rotate up or down becoming more or less steep if investors become more or less risk averse. A firm can influence market risk (hence its beta coefficient) through changes in the composition of its assets and through changes in the amount of debt it uses. Quantitative Problem: You are given the following information for Wine and Cork Enterprises (WCE): RF 4%; TM = 7%; RPM = 3%, and beta = 1.2 What is WCE's required rate of return? Do not round intermediate calculations. Round your answer to two decimal places. % If inflation increases by 1% but there is no change in investors' risk aversion, what is WCE's required rate of return now? Do not round intermediate calculations. Round your answer to two decimal places. % Assume now that there is no change in inflation, but risk aversion increases by 2%. What is WCE's required rate of return now? Do not round intermediate calculations. Round your answer to two decimal places. % If inflation increases by 1% and risk aversion increases by 2%, what is WCE's required rate of return now? Do not round intermediate calculations. Round your answer to two decimal places. %
Financial Reporting, Financial Statement Analysis and Valuation
8th Edition
ISBN:9781285190907
Author:James M. Wahlen, Stephen P. Baginski, Mark Bradshaw
Publisher:James M. Wahlen, Stephen P. Baginski, Mark Bradshaw
Chapter5: Risk Analysis
Section: Chapter Questions
Problem 11QE: Market equity beta measures the covariability of a firms returns with all shares traded on the...
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Transcribed Image Text:The security market line (SML) is an equation that shows the relationship between risk as measured by beta and the required rates of return on individual securities. The SML equation is given below:
Required return on Stock = Risk-free return + (Market risk premium) (Stock's beta)
If a stock's expected return plots on or above the SML, then the stock's return is sufficient ✓to compensate the investor for risk. If a stock's expected return plots below the SML, the stock's return
is insufficient to compensate the investor for risk.
The SML line can change due to expected inflation and risk aversion. If inflation changes, then the SML plotted on a graph will shift up or down parallel to the old SML. If risk aversion changes, then the
SML plotted on a graph will rotate up or down becoming more or less steep if investors become more or less risk averse. A firm can influence market risk (hence its beta coefficient) through changes in
the composition of its assets and through changes in the amount of debt it uses.
Quantitative Problem: You are given the following information for Wine and Cork Enterprises (WCE):
TRF = 4%; TM = 7%; RPM = 3%, and beta = 1.2
What is WCE's required rate of return? Do not round intermediate calculations. Round your answer to two decimal places.
%
If inflation increases by 1% but there is no change in investors' risk aversion, what is WCE's required rate of return now? Do not round intermediate calculations. Round your answer to two decimal
places.
%
Assume now that there is no change in inflation, but risk aversion increases by 2%. What is WCE's required rate of return now? Do not round intermediate calculations. Round your answer to two
decimal places.
%
If inflation increases by 1% and risk aversion increases by 2%, what is WCE's required rate of return now? Do not round intermediate calculations. Round your answer to two decimal places.
%
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