The monthly rate of return on T-bills is 1%. The market went up this month by 1.5%. In addition, AmbChaser, Inc., which has an equity beta of 2, surprisingly just won a lawsuit that awards it S1 million immediately a. If the original value of AmbChaser equity were $100 million, what would you guess was the rate of return of its stock this month? b. What is your answer to (a) if the market had expected AmbChaser to win $2 million?

a; 3%

b; 1%

Explanation:

To answer the question, we proceed as follows;

Firstly, we compute the rate of return:

The rate of return can be calculated using the CAPM model:

According to CAPM,

Rate Of return RE = Rf + β(Rm - Rf)

where, Rf = Risk free rate

Rm = Market return

β = Risk co-efficient

RE = Cost of equity

To find the rate of return, substitute 1% for risk free rate, 1.50% for market return and 2 for beta.

Applying the CAPM model, we get;

Rate of return = 0.01 + 2(0.015 - 0.01)

= 0.02 or simply 2%

Its firm's return due to the lawsuit is $1 million per $100 million initial equity; this means the increase is 1%.

Therefore, the total return should be ;

Total return = 1% + 2% = 3%

If the settlement was expected to be $2 million and the actual settlement has a loss of $1 million, then the firm-specific return would be = 1%

Total return = 2% - 1%

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