11. Calculating a potential investment return - Five steps Calculating a stock's potential rate of return takes five steps: Step 1 - Use the Stock's Beta Value to Estimate the Risk of the Investment A stock's beta value is a measure of the stock's volatility-that is, how much the stock price varies relative to the rest of the market as a whole. A stock's beta value can help you to estimate the amount of risk in an investment portfolio. For example, suppose you have just purchased stock in CQ Telecommunications that has a beta value of 1.6. If the average price of all stocks rises by 20% over a period of time, then you would expect the price of CQ Telecommunications stock to rise by C%. However, if the average price of all stocks falls by 10% over a period of time, then you would expect the price of CQ Telecommunications stock to fall by %. In general, a stock with a higher beta value is risky than a stock with lower beta value. Step 2 - Estimate the Market Risk To estimate the required rate of return on an investment, you must first estimate and quantify the market risk. Market risk (also known as systematic risk) is the risk associated with the effects of the overall market on securities markets. Market risk often causes the market price of a particular stock or bond to change, even though nothing has changed in the fundamental values underlying that investment. Historical records indicate that % represents a realistic estimate of market risk for U.S. stocks. However, in the short term or in times of economic turbulence, the market risk may be significantly Step 3 - Calculate your Required Rate of Return The return on short-term U.S. Treasury bills (T-bills) has historically exceeded the rate of inflation by a slight degree. For example, when T-bills pay 2% interest, the inflation rate might be around In this case, T-bills provide almost no gain the investor, because inflation income taxes reduce the return to about zero. Therefore, investors often use the yield on Treasury bills as a base number that provides a zero real rate of return, that is a zero return on an investment after inflation and income taxes. To calculate your required rate of return on an investment, multiply the investment's beta value by the estimated market risk and then add the risk- free T-bill rate as shown in the following equation: Estimate of the Required Rate of Return on an Investment = T-bill Rate +(Beta x Market Risk) For example, suppose that the stock for CQ Telecommunications has a beta value of 1.6. If you assume a market risk of 8% and the current T-bill rate is 2.0%, the total rate of return you will require on this investment is C%. (Hint: Round your answer to one decimal place.) In other words, you would need a promise of a higher rate of return than this percentage in order to justify putting your money at risk in this investment