If the firm is being operated so as to maximize shareholder wealth, and if our basic assumptions concerning the relationship between risk and return are true, then which of the following should be true?
A) If the beta of the asset is larger than the firm's beta, then the required return on the asset is less than the required return on the firm.
B) If the beta of the asset is smaller than the firm's beta, then the required return on the asset is greater than the required return on the firm.
C) If the beta of the asset is greater than the corporate beta prior to the addition of that asset, then the corporate beta after the purchase of the asset will be smaller than the original corporate beta.
D) If the beta of an asset is larger than the corporate beta prior to the addition of that asset, then the required return on the firm will be greater after the purchase of that asset than prior to its purchase.
E) If the beta of an asset is larger than the firm's beta, then the required rate of return is equal to the beta.

Question

Quizplus · Accepted Answer

According to the Capital Asset Pricing Model (CAPM), the required rate of return for a particular asset is determined by its beta and the market risk premium. As such, a higher beta indicates higher systematic risk, which commands a higher required return to compensate investors.

Assuming the firm is maximizing shareholder wealth, it will seek to add assets that offer the highest return for a given level of risk. Therefore, if the beta of an asset is larger than the corporate beta prior to its addition, this suggests that the asset is riskier than the firm's current investment portfolio. Consequently, the required return on the firm will be greater after the purchase of that asset than prior to its purchase in order to compensate investors for the added risk.

If the Firm Is Being Operated So as to Maximize