Question

Data for Hugh's Corporation is provided below. Hugh's recently acquired some risky assets that caused its beta to increase by 30%. What is the stock's new expected rate of return according to the CAPM? Initial beta 1.00 Initial expected return (rs) 10.20% Market risk premium, E(Rm - Rrf) 6.00% Percentage increase in beta 30.00% Increase in inflation premium 2.00% 16.21% 12.00% 14.70% 15

Answer 1

Formula of CAPM is,

Expected Return (Er) = Risk free rate(Rf) + (Market Risk Premium) * Beta

Er before acquisition of risky assets

10.20% = Rf + 6*1

Rf = 4.20%

Er after acquisition of risky assets

Er = Rf (Nominal rate) + Market Risk Premium * Revised Beta

= 4.20% + 6*(1*1.30)

= 12%

Note :- We always take Risk free nominal rate which is inclusive of inflation,here also in the absence of information whether it is real or nominal it is assumed that it is nominal rate which means the effect of inflation is already done.