The current market value of the 500,000 preferred shares of Clumsy Sports Inc.is $25 million.If the shares pay an annual dividend of $5 on a par value of $85 and the risk-free rate is 5.5 %, what is the implied risk premium?

Question

Quizplus · Accepted Answer

First, you need to calculate the current yield on the preferred shares:
Current yield = Annual dividend / Market value per share
Current yield = $5 / ($85*0.5) = 0.0588 or 5.88%

Then, you can use the capital asset pricing model (CAPM) to calculate the implied risk premium:
CAPM = Risk-free rate + Beta * (Market return - Risk-free rate)

As there is no information on beta, we can assume that it is 1 (the market average). Also, we can assume that the market return is equal to the historical average market return of 10%.

Implied risk premium = CAPM - Risk-free rate
Implied risk premium = (10% - 5.5%) - 5.5% = 4.5%

Therefore, the implied risk premium for the 500,000 preferred shares of Clumsy Sports Inc. is 4.5%, which corresponds to choice B.

The Current Market Value of the 500,000 Preferred Shares of Clumsy