Question

Bosco, Inc. has a beta coefficient of 1.5 and a required rate of return of 17%. The market risk premium is currently 5%. If inflation premium increases by 3 percentage points and Bosco invests in a new project which increases its beta by 70 percent, what will be the company's new required rate of return according to the CAPM?

Answer #1

Using CAPM | |||||

Market Risk Premium = | 5.00% | ||||

Beta (B)= | 1.50 | ||||

Required Rate of Return= | 17% | ||||

Required Rate of Return ( Ke)= | Rf + B x Marker Risk Premium | ||||

17%= | Rf + 1.50x 5.00% | ||||

17%= | Rf + 7.50% | ||||

Rf= | 17%-7.5% | ||||

Rf= | 9.50% | ||||

If Inflation increase by 3% | |||||

then | |||||

New Rf= | 9.5% + 3 %= 12.5% | ||||

Market Risk Premium = | 5.00% | ( no impact of inflation on risk premium) | |||

New Beta= | 1.5+ 1.5 x 70%= 1.5+1.05 = 2.55 | ||||

New required rate of return= | Rf + B x Marker Risk Premium | ||||

New required rate of return= | 12.5% + 2.55 x 5.00% | ||||

New required rate of return= | 12.5% + 12.75% | ||||

New required rate of return= | 25.25% |

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