Question

HR Industries (HRI) has a beta of 2.1, while LR Industries's (LRI) beta is 0.9. The risk-free rate is 6%, and the required rate of return on an average stock is 13%. The expected rate of inflation built into r_RF falls by 1.5 percentage points; the real risk-free rate remains constant; the required return on the market falls to 10.5%; and all betas remain constant. After all of these changes, what will be the difference in the required returns for HRI and LRI? Round your answer to two decimal places.

Answer 1

The required return of HRI is computed as shown below:

= Risk free rate + Beta x (return on market - risk free rate)

Risk free rate is computed as follows:

= current risk free rate - decrease in inflation rate

= 6% - 1.5%

= 4.5% or 0.045

So, the required return will be as follows:

= 4.5% + 2.1 x (10.5% - 4.5%)

= 17.10%

The required return of LRI is computed as shown below:

= Risk free rate + Beta x (return on market - risk free rate)

Risk free rate is computed as follows:

= current risk free rate - decrease in inflation rate

= 6% - 1.5%

= 4.5% or 0.045

So, the required return will be as follows:

= 4.5% + 0.9 x (10.5% - 4.5%)

= 9.90%

So, the difference in returns will be computed as follows:

= 17.10% - 9.9%

= 7.20%

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