Then, plug that into the CAPM to get the expected return:
43.10
10.Take the following as given:
Company A has an asset beta of 1.2 and is 70% equity and 30% debt financed.
The expected return on the market is 12% and the risk free rate is 3%.
The beta of the company's debt is 0.
a.What is the expected return on the equity of company A? (3)
First figure out the equity beta for company A:
Then, plug that into the CAPM to get the expected return:
E[Re]=.03+1.714(.12-.03)=0.184
b.How much of the expected return on the equity comes from financial risk? (4)
The expected return on equity comes from financial risk and asset risk. The part that comes from asset risk can be calculated using the asset beta:
E[Ra]=.03+1.2(.12-.03)=.138
Thus, the remaining .184-.138=.046 return is for financial risk.