Suppose that two factors have been identified for the U. S. economy: the growth rate of industrial production, IP, and the inflation rate, IR. IP is expected to be 4%, and IR 3.0%. A stock with a beta of 1.1 on IP and 0.5 on IR currently is expected to provide a rate of return of 7%. If industrial production actually grows by 7%, while the inflation rate turns out to be 5.0%, what is your revised estimate of the expected rate of return on the stock

11.3%

Explanation:

Given that,

Growth rate of industrial production, IP = 4%

Inflation rate, IR = 3.0%

Beta = 1.1 on IP

Beta = 0.5 on IR

Rate of return = 7%

Before the changes in industrial production and inflation rate:

Rate of return = α + (Beta on IP) + (Beta on IR)

7% = α + (1.1 × 4%) + (0.5 × 3%)

7% = α + 4.4% + 1.5%

7% - 4.4% - 1.5% = α

1.1% = α

With the changes:

Rate of return:

= α + (Beta on IP) + (Beta on IR)

= 1.1% + (1.1 × 7%) + (0.5 × 5%)

= 1.1% + 7.7% + 2.5%

= 11.3%

Therefore, the revised estimate of the expected rate of return on the stock is 11.3%.

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