Question

HR Industries (HRI) has a beta of 1.8, while LR Industries' (LRI) beta is 0.6. The risk-free rate, rRF, is 6%, and the required rate of return on an average stock is 13%. The expected rate of inflation built into rRF falls by 1.5 percentage points, the real risk-free rate remains constant, the required return on the market falls to 10.5%, and all betas remain constant. After all of these changes, what will be the difference in the required returns for HRI and LRI?

A) 6.6%

B) 6.8%

C) 7.2%

D) 7.0%

E) 7.4%

Answer 1

C) 7.2%

Beta of HR – 1.8; Beta of LR – 0.6 and there are no changes

Risk-Free Rate – 6% but falls by 1.5 to 4.5%

Required Rate of Return – 13% and falls to 10.5%

Required Return on Stock = Risk-Free Return + (Market Risk Premium)(Stock’s Beta)

HR Industries:

Required Return on Stock = 4.5% + (10.5% - 4.5%) (1.8) = 15.3%

LR Industries:

Required Return on Stock = 4.5% + (10.5% - 4.5%) (0.6) = 8.1%

The difference in the required returns for HRI and LRI is = 15.3% - 8.1% = 7.2%