Using CAPM, calculate the required rate of return for a stock with beta 1.3, market risk premium 7%, and risk-free rate 6.5%. Then determine if the stock meets the criterion of above-average-risk stocks only if rewarded.

Using CAPM, calculate the required rate of return for a stock with beta 1.3, market risk premium 7%, and risk-free rate 6.5%. Then determine if the stock meets the criterion of above-average-risk stocks only if rewarded.

• A. The required rate of return is 15.6%, and the stock meets Allen's criteria.
• B. The required rate of return is 12.4%, and the stock does not meet Allen's criteria.
• C. The required rate of return is 14.9%, and the stock meets Allen's criteria.
• D. The required rate of return is 17.6%, and the stock meets Allen's criteria.

Answer: (A)

CAPM says the required return equals the risk-free rate plus the stock’s beta times the market risk premium. Here that’s 6.5% + (1.3 × 7%) = 6.5% + 9.1% = 15.6%. A beta above 1 means above-average market risk, so the stock should have a higher required return than the overall market. The market’s expected return under CAPM is 6.5% + 7% = 13.5%. Since 15.6% exceeds 13.5%, the stock is rewarded for its higher risk, aligning with Allen’s criterion for above-average-risk stocks being rewarded. Thus the required return is 15.6%, and the stock meets Allen’s criterion.

CAPM says the required return equals the risk-free rate plus the stock’s beta times the market risk premium. Here that’s 6.5% + (1.3 × 7%) = 6.5% + 9.1% = 15.6%.

A beta above 1 means above-average market risk, so the stock should have a higher required return than the overall market. The market’s expected return under CAPM is 6.5% + 7% = 13.5%. Since 15.6% exceeds 13.5%, the stock is rewarded for its higher risk, aligning with Allen’s criterion for above-average-risk stocks being rewarded.

Thus the required return is 15.6%, and the stock meets Allen’s criterion.