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 6%, and IR 3.0%. A stock with a beta of 1.3 on IP and 0.7 on IR currently is expected to provide a rate of return of 9%. If industrial production actually grows by 8%, while the inflation rate turns out to be 4.0%, 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.)

Revised expected rate of return

%

Answer 1

Let the risk free rate be "X"

Expected return =Rf+ [Beta(IP-Rf)]+[Beta(IR-Rf)]

    9 = x + [1.3(6-x)]+[.7(3-x)]

   9 =x + 7.8 - 1.3x +2.1 -.7x

   9 = -1 x + 9.9

   1x = 9.9-9

   x = .90/1 = .90

Revised expected rate of return = .90 +[1.3(8-.90)]+[.7(4-.9)]

        = .90 + [1.3*7.1]+[.7*3.1]

       = .9 + 9.23+ 2.17

      = 12.30%