Question

The Simpson Corporation is thinking about investing in two new options, each option has a different level of risk that is associated with it. Option (A) is a new product and it is investing in a new market. Option (B) is an expansion of a well-established existing market. The risk-free rate is 2% and the expected rate of inflation is 3%. For a low risk investment Simpson Corporation expects 2%, but for a high risk investment Simpson Corporation expects 5%.

Calculate the required rate of return for options A and B.

Please show work so I can verify I understand. Thank you

Answer 1

Option (A):NEW PRODUCT IN A NEW MARKET

In this case product and market are not known. There is more uncertainty , hence high risk in this investment,

Simpson corporation should expect a real premium on return =5%

Risk free rate=2%

Expected real return=5+2=7%

Expected Inflation rate=3%

Hence the expected nominal return=7+3=10%

Required rate of return for option (A)=10%

Option (B):EXPANSION OF A WELL ESTABLISHED EXISTING MARKET

In this case product and market are known. There is very low uncertainty , hence low risk in this investment,

Simpson corporation should expect a real premium on return =2%

Risk free rate=2%

Expected real return=2+2=4%

Expected Inflation rate=3%

Hence the expected nominal return=4+3=7%

Required rate of return for option (B)=7%