Question

HR Industries (HRI) has a beta of 1.4, while LR Industries's (LRI) beta is 1.0. The risk-free rate 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? Round your answer to two decimal places.

Answer 1

before adjustment:

HRI 13%

LRI 15.8%

difference 2.8%

after adjustment

HRI 10.5% ↓2.5%

LRI 12.9% ↓2.9%

difference 2.4%

Step-by-step explanation:

we will valuate the CAPM for both companies:

before adjustment

`Ke= r_f + \beta (r_m-r_f)`

risk free 0.06

market rate 0.13

premium market =(market rate - risk free) 0.07

LRI: beta(non diversifiable risk) 1

`Ke= 0.06 + 1 (0.07)`

LRI Ke 0.13000

HRI ke: beta(non diversifiable risk) 1

`Ke= 0.06 + 1.4 (0.07)`

HRI Ke 0.15800

With the changes:

`Ke= r_f + \beta (r_m-r_f)`

risk free 0.045

market rate 0.105

premium market =(market rate - risk free) 0.06

LRI: beta(non diversifiable risk) 1

`Ke= 0.045 + 1 (0.06)`

LRI Ke 0.10500

HRI beta(non diversifiable risk) 1.4

`Ke= 0.045 + 1.4 (0.06)`

HRI Ke 0.12900