Question

Suppose two factors are identified for the U.S. economy: the growth rate of industrial production, IP, and the inflation rate, IR. IP is expected to be 3% and IR 6%. A stock with a beta of 1 on IP and 0.3 on IR currently is expected to provide a rate of return of 16%. If industrial production actually grows by 4%, while the inflation rate turns out to be 7%, what is your best guess for the rate of return on the stock? (Round your answer to 1 decimal place.) Rate of return

Answer 1

The rate of return on the stock is computed as shown below:

= Expected rate of return + IP estimate + IR estimate

Expected rate of return = 16% or 0.16

IP estimate is computed as shown below:

= Beta of IP x ( IP actual growth - expected inflation )

= 1 x ( 0.04 - 0.03 )

= 0.01

IR estimate is computed as shown below:

= Beta of IR x ( IR actual growth - expected inflation )

= 0.3 x ( 0.07 - 0.06 )

= 0.003

So by plugging these values in the above mentioned formula, we shall get:

= 0.16 + 0.01 + 0.003

= 17.3%

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