Suppose you forecast that the market index will earn a return of 12% in the coming year.Treasury bills are yielding 4%.The unadjusted β of Mobil stock is 1.30.A reasonable forecast of the return on Mobil stock for the coming year is _________ if you use a common method to derive adjusted betas.
A)15.0%
B)15.5%
C)16.0%
D)14.6%
E)none of the above

Question

Quizplus · Accepted Answer

A common method to derive adjusted betas is through the following formula:

Adjusted Beta = Unadjusted Beta x (1 + (1 - tax rate) x (Debt/Equity))

Assuming Mobil's debt-to-equity ratio is 0.5 and a tax rate of 40%, we have:

Adjusted Beta = 1.30 x (1 + (1 - 0.4) x 0.5) = 1.56

Using the capital asset pricing model (CAPM), we can then calculate Mobil's expected return:

Expected return = Risk-free rate + Beta x Market risk premium
Expected return = 4% + 1.56 x 12% = 14.96%, which is closest to 14.6%. Therefore, the answer is D).

Suppose You Forecast That the Market Index Will Earn a Return