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Hi sir how do i do the following question below, when the equity and debt financing mix in not given .
Qn) The shares of T Co have a beta of 0.4 and investors have an expected rate of return of 6%. The shares of Ole Co have a beta of 1.5. The expected returns to the market are 12%.
Using the CAPM, what is the expected rate of return for investors in Ole Co?
The answer is : 17%
Another question. Can i know why the statement below is incorrect ?
Statement: A share that has a beta of 1.0 will have an expected return equal to the risk free rate.
Is it because of the fact that if the share is risk-free, the beta is supposed to be 0 ?
First question:
The mix of debt and equity is irrelevant.
For T: 6% = Rf + 0.4 x (12% – Rf).
So you can rearrange and calculate the risk free rate.
Once you have the risk free rate, you can apply Ole’s beta and calculate the return to Ole’s shareholders.
(I am puzzled that your book did not show the workings for this!)Second question:
Yes – if the share were risk free then the beta would be 0.
(Because the beta is 1 it means it is giving the same return as the market)Okay thanks sir. It’s because these question i’m practicing now, is from my lecture notes. The workings are not given; only the answers are given. For the questions in my ACCA approved exam kit, I have all the workings , so wouldn’t be much of a problem.
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