Answer (B) is correct . The required rate of return on equity capital can be estimated with the capital asset pricing model (CAPM). CAPM consists of adding the risk-free rate (i.e., the return on government securities, denoted R F) to the product of the beta coefficient (a measure of the issuer’s risk) and the difference between the market return and the risk-free rate (denoted R M ?–?R , referred to as the risk premium). Below is the basic equilibrium equation for the CAPM: Required rate of return = R F + β(R M – RF) In this situation, the risk premium is 5% (10% – 5%). Thus, the required rate of return when the beta coefficient is 1.2 is 11% [5%?+ (1.2 × 5%)], and when the beta coefficient is 1.5, the required rate is 12.5% [5% + (1.5 × 5%)]. This is an increase of 1.5% (12.5% – 11%).
Answer (A) is incorrect because The market return times the increase in the beta equals 3%.
Answer (C) is incorrect because The company’s required rate of return is affected by a change in the company’s beta coefficient.
Answer (D) is incorrect because The change results in an increase of the company’s required rate of return, not a decrease.
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