Answer (A) 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) The risk premium is 5% (11% – 6%). ? The CAPM can be thus applied to each of the three investments as follows: Investment A: 6% + (1.4 × 5%) = 13.0% Investment B: 6% + (0.8 × 5%) = 10.0% Investment C: 6% + (1.5 × 5%) = 13.5% These required rates of return can be compared to the expected rates to evaluate which investments should be accepted and which should be rejected.
Answer (B) is incorrect because The required rates of return for Investment A and Investment C exceed their expected returns.
Answer (C) is incorrect because The required rate of return for Investment C exceeds its expected return.
Answer (D) is incorrect because The required rates of return for Investment A and Investment C exceed their expected returns.
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The return on the market is 11% and the risk-free rate is 6%. If the capital asset pricing model (CAPM) is used for calculating the required rate of return, which investments should the management of Sky make?