Gardner Electric has a beta of 0.88 and an expected dividend growth rate of 4.00% per year.The T-bill rate is 4.00%, and the T-bond rate is 5.25%.The annual return on the stock market during the past 4 years was 10.25%.Investors expect the average annual future return on the market to be 12.50%.Using the SML, what is the firm's required rate of return?
A) 11.34%
B) 11.63%
C) 11.92%
D) 12.22%
E) 12.52%

Question

Quizplus · Accepted Answer

Using the SML formula: 
Required rate of return = Risk free rate + Beta(market return - risk free rate)
We are given: 
Beta = 0.88
Dividend growth rate = 4%
T-bill rate = 4%
T-bond rate = 5.25%
Average annual future return on the market = 12.50%
Using the past 4 years' stock market return, we can calculate the market return as:
(1 + 0.1025)(1 + 0.1025)(1 + 0.1025)(1 + 0.1025) - 1 = 46.38%
Risk premium = Average annual future return on the market - T-bond rate = 12.50% - 5.25% = 7.25%
Required rate of return = 4% + 0.88(7.25%) = 11.63%

Gardner Electric Has a Beta of 0