256 Part 3 Financial Assets
Figure 8-10 illustrates an increase in risk aversion. The market risk premium rises
from 5% to 7.5%, causing rM to rise from rM1 $ 11% to rM2 $ 13.5%. The returns on other
risky assets also rise, and the effect of this shift in risk aversion is more pronounced on
riskier securities. For example, the required return on Stock L with bA $ 0.5 increases
by only 1.25 percentage points, from 8.5% to 9.75%, whereas the required return on a
stock with a beta of 1.5 increases by 3.75 percentage points, from 13.5% to 17.25%.8-4c Changes in a Stock’s Beta Coefficient
As we will see later in the book, a " rm can in! uence its market risk (hence, its beta)
through changes in the composition of its assets and through changes in the amount
of debt it uses. A company’s beta can also change as a result of external factors such
as increased competition in its industry and expiration of basic patents. When such
changes occur, the " rm’s required rate of return also changes; and as we will see in
Chapter 9, this change will affect its stock price. For example, consider Allied Food
Products, with a beta of 1.48. Now suppose some action occurred that caused
Allied’s beta to increase from 1.48 to 2.0. If the conditions depicted in Figure 8-8
held, Allied’s required rate of return would increase from 13.4% to 16%:r 1 " rRF $ (rM! rRF)bi
" 6% $ (11% # 6%)1.48
" 13.4%
to
r 2 " 6% $ (11% # 6%)2.0
" 16.0%0 0.5 1.0 1.5 2.0 Risk, b irA 2 = rM 2 = 13.5rRF = 6Required Rate
of Return (%)New Market Risk Premium,
rM2 – rRF = RPM2 = RPA2 = 7.5%Original Market Risk
Premium, rM1 – rRF = 5%rL 1 = 8.5rL 2 = 9.75rA 1 = rM1 = 1117.25SML 2 = 6% + 7.5%(bi)SML 1 = 6% + 5%(bi)Shift in the SML Caused by Increased Risk Aversion
F I G U R E 8!1 0