Suppose you are given the following information. The beta of company i, bi, is 1.1, the risk-free rate, rRF, is 7 percent, and the expected market premium, rM - rRF, is 6.5 percent. (Assume that ai = 0.0.)
a. Use the Security Market Line (SML) of CAPM to find the required return for this company.
b. Because your company is smaller than average and more successful than average (that is, it has a low book-to-market ratio), you think the Fama-French three factor model might be more appropriate than the CAPM. You estimate the additional coefficients from the Fama-French three-factor model: The coefficient for the size effect, ci, is 0.7, and the coefficient for the book-to-market effect, di, is -0.3. If the expected value of the size factor is 5 percent and the expected value of the book-to-market factor is 4 percent, what is the required return using the Fama-French three-factor model?