Question

The US government T-bill has a yield of 0.05, the Wilshire 5000 is expected to yield 0.09, and a stock's beta is 0.9. If inflation is expected to increase by 0.05 next year, but everything else remains the same, what will the new cost of retained earnings be?

Answer 1

Risk free rate of return (US government t-bills) = 0.05

Market return (wilshare 5000) = 0.09

Stock beta = 0.9

As per CAPM model, cost of retained earnings (equity) = Risk free rate of return + (Beta *(Market return-Risk free return))

= 0.05 + (0.9*(0.09-0.05))

= 0.086

Real Return Expected is = 0.086

Inflation rate = 0.05

Nominal rate of return =((1+real return)*(1+Inflation rate)-1

((1+0.086)*(1+0.05))-1

0.1403

So, new cost of retained earnings shall be 0.1403