Question

Suppose that two factors have been identified for the U.S. economy: the growth rate of industrial production, IP, and the inflation rate, IR. IP is expected to be 5%, and IR 4.0%. A stock with a beta of 2.1 on IP and 1.4 on IR currently is expected to provide a rate of return of 18%. If industrial production actually grows by 6%, while the inflation rate turns out to be 5.8%, what is your revised estimate of the expected rate of return on the stock? (Do not round intermediate calculations. Round your answer to 1 decimal place.)

Answer 1

The revised estimate of the expected rate of return is computed as follows:

Expected rate of return = Risk free rate + IP x Beta of IP + IR x Beta of IR

0.18 = risk free rate + 0.05 x 2.1 + 0.04 x 1.4

0.18 = risk free rate + 0.105 + 0.056

risk free rate = 1.9%

So, the revised estimate will be as follows:

Expected rate of return = Risk free rate + IP x Beta of IP + IR x Beta of IR

= 1.9% + 0.06 x 2.1 + 0.058 x 1.4

= 22.62%

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