Question

Company X has beta = 1.6, while Company Y's beta = 0.7. The risk-free rate is 7%, and the required rate of return on an average stock is 12%. Now the expected rate of inflation built into rRF rises by 1 percentage point, the real risk-free rate remains constant, the required return on the market rises to 14%, and betas remain constant. After all of these changes have been reflected in the data, by how much will the required return on Stock X exceed that on Stock Y?
a. 5.40%
b. 5.75%
c. 3.75%
d. 4.82%
e. 4.20%

Answer 1

Answer:

a. 5.40%

Explanation:

First, I will calculate the new cost of equity for both stock X and Y:

Required rate of return = risk free rate + (beta x market premium)

Re stock X = 8% + (1.6 x 6%) = 8% + 9.6% = 17.6%

Re stock Y = 8%  + (0.7 x 6%) = 8% + 4.2% = 12.2%

The difference between the required rate of return = 17.6% - 12.2% = 5.4%