Question 7 (8 points) Investors expect the market rate of return in the coming y

Question

Question 7 (8 points) Investors expect the market rate of return in the coming year to be 13%. The risk-free rate is 3%. QQAG has a beta of 1.7. The market value of its outstanding equity is $200 million. (1) What is your best guess currently as to the expected rate of return on QQAG's stock if you believe that the stock is fairly priced?. 4 4 (2) If the market return in the coming year actually turns out to be 10%, what is your best guess as to the rate of return that will be earned on QQAG's stock? 4 (3) Continue from (2) and suppose now that QQAG loses a surprising lawsuit during the year. QQAG's stock return during the year turns out to be 10%, what is your best guess as to the settlement amount paid by QQAG?

Explanation / Answer

(1) expected rate of return

Rf = risk free rate = 3%, Rm=return on market = 17%, beta = 1.7

ke = Rf + beta(Rm-Rf) = 3% + 1.7(13%-3%) = 3% + 17% =20%

(2) now if market return is 10%

ke = Rf + beta(Rm-Rf) = 3% + 1.7(10%-3%) = 3% + 11.9% =14.9%

(3) Due to law suit, stock return is at 10% and when we calculated by using the equation in oprion (2), it was 14.9%

so there is a loss of 4.9%.  

so amount of law suit paid = 4.9% x market value of equity = 4.9% ($200 million) = $9.8 million  

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