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 2%, and IR 4%. A stock with a beta of 1.2 on IP and 0.7 on IR currently is expected to provide a rate of return of 10%. If industrial production actually grows by 5%, while the inflation rate turns out to be 7%, what is the revised estimate of the expected rate of return on the stock?

15.3%

Explanation:

The computation of the revised estimated of the expected rate of return on the stock is shown below:

For Before

Rate of return = Standard deviation + (IP × beta + IR × beta)

10% = Standard deviation + (2% × 1.2) + (4% × 0.7)

10% = Standard deviation + 2.4% + 2.8%

So, the standard deviation is 4.4%

Now after changes the expected rate of return is

After

Rate of return = Standard deviation + (Growth rate × beta + Inflation rate × beta)

= 4.4% + (5% × 1.2) + (7% × 0.7)

= 4.4% + 6% + 4.9%

= 15.3%