Aziz Equipment Co. invests in a group of risky projects, which increases the unsystematic risk of the firm, but does not change the systematic risk of the firm. All else the same, the expected risk premium on its common stock is most likely to:
A) Increase, because the difference between the expected return on the firm's stock and the risk-free rate will widen.
B) Decrease, because the difference between the expected return on the firm's stock and the risk-free rate will narrow.
C) Remain unchanged, because the level of systematic risk is unchanged.
D) Increase or decrease, depending on the internal rate of return of the new projects.
E) Decrease, because the difference between the expected return on the firm's stock and the risk-free rate will widen.

Question

Quizplus · Accepted Answer

The expected risk premium on a company's common stock is primarily determined by its systematic risk, as measured by its beta in the Capital Asset Pricing Model (CAPM). Since the systematic risk of Aziz Equipment Co. remains unchanged despite the increase in unsystematic risk due to the investment in risky projects, the expected risk premium on its common stock is most likely to remain unchanged. Unsystematic risk can be diversified away by investors, so it does not affect the risk premium demanded by investors.