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- 3 Marks
Question
The market is currently yielding a return of 16% while Treasury bills are yielding 10%. Shares of Lime Spider Ltd have a covariance of 7.5 with the market, while the market has a variance of 4.5.
Required:
Determine the required rate of return for Lime Spider Ltd’s shares
Answer
Using the Capital Asset Pricing Model (CAPM):
- Market return (Rm) = 16%
- Risk-free rate (Rf) = 10%
- Covariance of Lime Spider shares with the market (CovLs) = 7.5
- Market variance (σ²m) = 4.5
Step 1: Calculate Beta (β):
β = CovLs / σ²m
= 7.5 / 4.5
= 1.67
Step 2: Apply CAPM formula:
E(RLs)=Rf+β(Rm−Rf)E(R_{Ls}) = Rf + β (Rm – Rf)
= 10% + 1.67 × (16% – 10%)
= 10% + 1.67 × 6%
= 10% + 10.02%
= 20.02%
Conclusion:
The required rate of return for Lime Spider Ltd’s shares is 20%.
OR
- Tags: CAPM, Financial management, Required Rate of Return, Share Price
- Level: Level 3
- Topic: Theories of capital structure
- Series: MAY 2018
- Uploader: Theophilus