Nile Food's stock has a beta of 1.4, while Elba Eateries' stock has a beta of 0.7. Assume that the risk-free rate, rRF, is 5.5% and the market risk premium, (rM – rRF), equals 4%. Which of the following statements is CORRECT?
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Complete question:
Nile Food's stock has a beta of 1.4, while Elba Eateries' stock has a beta of 0.7. Assume that the risk-free rate, rRF, is 5.5% and the market risk premium, (rM− rRF), equals 4%. Which of the following statements is CORRECT?
a.If the risk-free rate increases but the market risk premium remains unchanged, the required return will increase for both stocks but the increase will be larger for Nile since it has a higher beta.
b.If the market risk premium increases but the risk-free rate remains unchanged, Nile's required return will increase because it has a beta greater than 1.0 but Elba's required return will decline because it has a beta less than 1.0.
c.Since Nile's beta is twice that of Elba's, its required rate of return will also be twice that of Elba's.
d.If the risk-free rate increases while the market risk premium remains constant, then the required return on an average stock will increase.
e.If the market risk premium decreases but the risk-free rate remains unchanged, Nile's required return will decrease because it has a beta greater than 1.0 and Elba's will also decrease, but by more than Nile's because it has a beta less than 1.0
Option D, If the risk-free rate increases while the market risk premium remains constant, then the required return on an average stock will increase.
Explanation:
The risk-free return return rate is the estimated return rate of such an zero-risk investment. The risk-free rate reflects an investor's value that a guaranteed risk-free investment would assume over a given period of time.
The increased risk-free limit contributes to a decline in capital costs, even if there is still a steady market risk premium. The calculation below clearly shows that the rise in the free rate of risk has a direct impact on the expected equity return.
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