As an equity analyst you are concerned with what will happen to the required ret

Question

As an equity analyst you are concerned with what will happen to the required return to Universal Toddler Industries' stock

as market conditions change. Suppose rRF=5%, rM=12% and bUTI=1.4.

a. Under current conditions, what is rUTI, the required rate of return on UTI stock?

b. Now suppose rRF(1) increases to 6% or (2) deacreases to 4%. The slope of SML remains constant. How would this affect rM and rUTI?

c. Now assume rRF remains at 5% but rM (1) increases to 14% or (2) falls to 11%. The slope of SML does not remain constant. How would these changes affect rUTI?

c. Now assume rRF remains at 5% but rM (1) increases to 14% or (2) falls to 11%. The slope of SML does not remain constant. How would these changes affect rUTI?

Explanation / Answer

a) r = RFR + Beta*(MR -RFR) = 0.05 + 1.4*(0.12 - 0.05) = 0.148 = 14.8%

b) Beta = (r -RFR)/(MR-RFR) = constant = 1.4

1.4*MR - r = (1.4 - 1)*RFR = 0.4RFR

Any change in RFR affects has the same change on MR and r to maintain Beta constant

c)Beta = (r -RFR)/(MR-RFR) = 1.4

To maintain constant Beta r has to increase by the amount 0.14MR if MR increases by 14% and decrease by 0.11MR if MRdecreases by 11%

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