Dixon Food's stock has a beta of 1.4, while Clark Café's stock has a beta of 0.7. Assume that the risk-free rate, rRF, is 5.5% and the market risk premium, (rM - rRF), equals 4%. Which of the following statements is CORRECT?
A) if the market risk premium increases but the risk-free rate remains unchanged, dixon's required return will increase because it has a beta greater than 1.0 but clark's required return will decline because it has a beta less than 1.0.
B) since dixon's beta is twice that of clark's, its required rate of return will also be twice that of clark's.
C) if the risk-free rate increases while the market risk premium remains constant, then the required return on an average stock will increase.
D) if the market risk premium decreases but the risk-free rate remains unchanged, dixon's required return will decrease because it has a beta greater than 1.0 and clark's will also decrease, but by more than dixon's because it has a beta less than 1.0.
E) if the risk-free rate increases but the market risk premium remains unchanged, the required return will increase for both stocks but the increase will be larger for dixon since it has a higher beta.

Question

Quizplus · Accepted Answer

The required return on an average stock is equal to the risk-free rate plus the product of the market risk premium and the stock's beta. Therefore, an increase in the risk-free rate will cause the required return on all stocks to increase, holding everything else constant. The other statements are either incorrect or incomplete.

Dixon Food's Stock Has a Beta of 1