Company A has a beta of 0.70, while Company B's beta is 1.20. The required return on the stock market is 11.00%, and the risk-free rate is 4.25%.

What is the difference between A's and B's required rates of return?

(Hint: First find the market risk premium, then find the required returns on the stocks.)

a) 2.75% b) 2.89% c) 3.05% d) 3.21% e) 3.38%

e) 3.38%

Explanation:

In this question, we apply the Capital Asset Pricing Model (CAPM) formula which is shown below

Required rate of return = Risk-free rate of return + Beta * (Market rate of return - Risk-free rate of return)

For A

= 4.25% + 0.70 * (11.00% - 4.25%)

= 4.25% + 0.70 * 6.75%

= 4.25% + 4.725%

= 8.975%

For B

= 4.25% + 1.20 * (11.00% - 4.25%)

= 4.25% + 1.20 * 6.75%

= 4.25% + 8.1%

= 12.35%

So, the difference would be

= 12.35% - 8.975%

= 3.375%

The (Market rate of return - Risk-free rate of return) is also known as market risk premium