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2 November, 23:50

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

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  1. 3 November, 02:54
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    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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