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 = 14

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

B. Now suppose rFR (1) increases to 6% or (2) decreases to 4%. The slope of the SMI remains constant. How would this affect rM and rUTI?

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

YOU MUST SHOW ALL WORK IN DETAIL AND FORMULAS.

Explanation / Answer

Please Note :- I think the bUTI should be 1.4 and not 14. I have solved it using 14 (as given in the question). You can change it to 1.4 if the given number is not right

(A) rUTI = rRF + (rM-rRF)*bUTI

= 5% + (12%-5%)*14

= 5% + 98%

= 103%

(B) rRF increases to 6% but the slope remains the same (which means that rM-rRF remains the same at 7% as calculated above)

We have, rM-rRF = 7% =>7% = rM - 6% => rM = 13%

rUTI = 6% + (7%)*14 = 104%

rRF deccreases to 4% but the slope remains the same (which means that rM-rRF remains the same at 7% as calculated above)

We have, rM-rRF = 7% =>7% = rM - 4% => rM = 11%

   rUTI = 4% + (7%)*14 = 102%

(C) rRF remains at 5% and rM increases to 14%

rUTI = 5% + (14%-5%)*14 = 5% + 126% = 131%

rRF remains at 5% and rM falls to 11%

rUTI = 5% + (11%-5%)*14 = 5% + 84% = 89%

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