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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.

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TomShelby

Answer:

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%

Explanation:

we will valuate the CAPM for both companies:

before adjustment

[tex]Ke= r_f + \beta (r_m-r_f)[/tex]  

risk free 0.06

market rate 0.13

premium market =(market rate - risk free) 0.07

LRI: beta(non diversifiable risk) 1  

[tex]Ke= 0.06 + 1 (0.07)[/tex]  

LRI Ke 0.13000

HRI ke: beta(non diversifiable risk) 1

[tex]Ke= 0.06 + 1.4 (0.07)[/tex]

HRI Ke    0.15800

With the changes:

[tex]Ke= r_f + \beta (r_m-r_f)[/tex]  

risk free 0.045

market rate 0.105

premium market =(market rate - risk free) 0.06

LRI: beta(non diversifiable risk) 1

[tex]Ke= 0.045 + 1 (0.06)[/tex]

LRI Ke 0.10500

HRI beta(non diversifiable risk) 1.4

[tex]Ke= 0.045 + 1.4 (0.06)[/tex]

HRI Ke 0.12900

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