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Question

MFI Inc has a beta of .86. If the expected market return is 11.5% and the risk free rate is 3%, what is the appropriate required return of MFI using CAPM? How do you find the risk free rate which is 7.5? I tried dividing, multiplying .86 and 11.5 but nothing.

Mohammad · Accepted Answer

As per CAPM:

Required Rate of Return = Risk Free Rate of Return + Beta(Expected Market Rate of Return - Risk Free Rate of Return )

http://www.investopedia.com/terms/c/capm.asp

By substituting values, we get:

Required Rate of Return = 3 + 0.86(11.5 - 3 ) = 10.31  i.e, 10.31%

Q:  How do you find the risk free rate which is 7.5^^? I tried dividing, multiplying .86 and 11.5 but nothing.

^^This portion is not clear.

We can find the Risk Free Return by using the the above mentioned formula:

Required Rate of Return = Risk Free Rate of Return + beta(Expected Market Rate of Return - Risk Free Rate of Return )

By applying values, we get:

10.31 = Risk Free Rate of Return + 0.86(11.5 - Risk Free Rate of Return )    OR

10.31 = Risk Free Rate of Return +9.89  -0.86 Risk Free Rate of Return    OR

0.42 = 0.14 Risk Free Rate of Return  ..(10.31 - 9.89 = 0.42) OR

0.42 = 0.14 Risk Free Rate of Return = 3   ie, 3%      .

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