Question

Please show work how to get the answer

A. The risk-free rate of interest is 6 percent, based on a premium for expected inflation of 3 percent. The expected return on the market is 15 percent. What is the required return on Mars’ common stock which has a beta of 0.6.Answer=11.4%

B. If the market risk premium remains constant, but the premium for expected inflation increases to 4 percent, what is the required return on Mars’ stock?Answer= 12.4%

C.nIf the premium for expected inflation returns to the original 3 percent but the expected return on the market increases to 16, what is the required return on Mars’ stock?Answer=12%

Answer 1

A.

As per CAPM :

required rate of return = risk free rate + beta*(martket risk premium)

here,

market risk premium = market return - risk free rate

=>15%- 6%

=>9%

risk free rate includes expected inflation of 3% within it.

=>6% + 0.6*(9%)

=>6% + 5.4%

=>11.4%.

B.if expected inflation increases to 4%....i.e 1% more than exisiting rate.

the risk free rate will be = 6%+1% =>7%.

required return here = risk free rate + beta *(market risk premium)

=>7% + 0.60*(9%)

=>7%+5.4%

=>12.4%.

C.now,

market risk premium will change => 16 % market return - 6% original risk free rate

=>10%.

required return = 6% + 0.6*(10%)

=>6%+6%

=>12%.