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 2%, and IR 4.1%. A stock with a beta of 1.9 on IP and 1.4 on IR currently is expected to provide a rate of return of 16%. If industrial production actually grows by 5%, while the inflation rate turns out to be 5.4%, what is your revised estimate of the expected rate of return on the stock?

Answer 1

IP rate =			2%
IR rate =			4.10%
IP Beta =			1.9
IR beta =			1.4
Expected rate of return =			16%
Actual IP rate =			5%
Actual IR rate =			5.40%
Expected rate of return = Risk free rate of return + (Beta of IP * IP factor) + (Beta of IR * IR factor)
16 = Risk-free rate of return + (1.9 * 2) + (1.4 * 4.1)
Risk free rate of return =			6.46
Revised expected rate of return = 6.46 + (1.9 * 5) + (1.4* 5.4)
			23.52
So, revised expected rate of return is 23.52%.