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STEEPER/FLATTER

The following graph plots the current security market line (SML) and indicates the return that investors require from holding stock from Happy Corp. (HC). Based on the graph, complete the table that follows: ? 20.0 18.0 12.0 Slope: 4.50 Y-Intercept: 5 Return on HC's Stock REQUIRED RATE OF RETURN(Percent) 8.0 0 0 0.5 1.5 2.0 1.0 RISK (Beta) 10.4% 5.9% 0.3 9.4% 5.5% 8.1% 1.9 8.8% 5.0% 3.4% 2.8 13.0% 2.8% 4.5% 1.2 10.4% RISK FRRE MARKET RISK FREE HAPPY CORP STOCK REQUIRED RATE OF RETURN Value CAPM Elements Risk-free rate (TRF) Market risk premium (RPM) Happy Corp. stock's beta Required rate of return on Happy Corp. stock L1 An analyst believes that inflation is going to increase by 2.0% over the next year, while the market risk premium will be unchanged. The analyst uses the Capital Asset Pricing Model (CAPM). The following graph plots the current SML. Calculate Happy Corp.'s new required return. Then, on the graph, use the green points (rectangle symbols) to plot the new SML suggested by this analyst's prediction. Happy Corp.'s new required rate of return is Tool tip: Mouse over the points on the graph to see their coordinates. 5.7 13.6% 12.4% 28.5. 20 New SML 16 12 REQUIRED RATE OF RETURN (Percent) 8 0 0 0.4 1.8 2.0 0.8 1.2 RISK (Beta) The SML helps determine the risk-aversion level among investors. The higher the level of risk aversion, the steeper the slope of the SML. Which of the following statements best describes the shape of the SML if investors were not at all risk averse? The SML would have a positive slope, but the slope would be flatter than it would be if investors were risk averse. The SML would have a positive slope, but the slope would be steeper than it would be if investors were risk averse. The SML would be a horizontal line. The SML would have a negative slope

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