Answer:
The answer is option (b) 11.5 %
Explanation:
Solution
Given that
Risk free rate =Rf
= 5%
The market portfolio expected return is = E[Rm]
= 13%
Volatility or standard deviation of market return=σm
=18%
Volatility or standard deviation of Monsters' Inc. return =σi
=24%
The correlation of Monsters' Inc. return with the market = 0.6
Thus
Beta of Monsters' Inc. is computed by applying the formula shown below:
βi =Cov (i,M)/σ²m =ρ * σi *σm/σ²m
= ρ * σi/ σm
Here,
Cov(i,m) is the Covariance between the stick and the market return which is given by the formula below:
Cov(i,m) = ρ* σi*σm
ρ refers to the correlation between the stock i return and Market return
Hence, Beta of Monsters' Inc. becomes:
βi = (0.6*24%)/18% = 0.8
Now we compute the required return on Monsters Inc we will use the CAPM Equation given as:
CAPM Equation:
E[Ri] = Rf + βi*(E[Rm]-Rf)
So,
The Required return on Monsters' Inc. stock = E[Ri] =5% + 0.8*(13% - 5%)
= 5%+6.4%
=11.4%
Therefore Monsters' required return is nearest to: 11.4 % or 11.5%
