Question

vto compensate the investor for risk. If a stock's expected return plots below the SML, the stock's return is insufficient to compensate the investor for risk. If a stock's expected return plots on or above the SML, then the stock's return is sufficient The SML line can change due to expected inflation and risk aversion. If inflation changes, then the SML plotted on a graph will shift up or down parallel to the old SML. If risk aversion changes, then the SML plotted on a graph will rotate up or down becoming more or less steep if investors become more or less risk averse. firm can influence market risk (hence its beta coefficient) through changes in the composition of its assets and through changes in the amount of debt it uses. Quantitative Problem: You are given the following information for Wine and Cork Enterprises (WCE): rRF 4%; rM = 8%; RPM =4%, and beta = 1.3 What is WCE's required rate of return? Round your answer to 2 decimal places. Do not round intermediate calculations. % If inflation increases by 2% but there is no change in investors' risk aversion, what is WCE's required rate of return now? Round your answer to two decimal places. Do not round intermediate calculations Assume now that there is no change in inflation, but risk aversion increases by 1%. What is WCE's required rate of return now? Round your answer to two decimal places. Do not round intermediate calculations If inflation increases by 2% and risk aversion increases by 1%, what is WCE's required rate of return now? Round your answer to two decimal places. Do not round intermediate calculations. Grade It Now Save & Continue Continue witheut.cavin

Answer 1

Given

r_F = 4%; r_M = 8%; RP_M = 4%; beta = 1.3

WCE's required rate of return:

= r_F + [beta x (r_M-r_F)] = 4% + [1.3 x (8% - 4%) = 9.20% ----- (A)

WCE's required rate of return if inflation increases by 2%, the market return should also increase by 2%, hence the market return = 8% + 2% = 10%.

Required Rate of return = 4% + [1.3 x (10% - 4%)] = 11.80% ----- (B)

WCE's required rate of return if investor aversion increases by 1%, the required rate of return will be (A) + 1% = 10.20%

WCE's required rate of return if investor aversion increases by 1% and inflation increases by 2%, the required rate of return will be (B) + 1% = 12.80%