Question

ABC Inc.'s stock has a 25% chance of producing a 10% return, a 50% chance of producing a 15% return, and a 25% chance of producing a -2% return.

a)What is the firm's expected rate of return?

i.17.50%

ii.14.33%

iii13.49%

iv.11.90%

v.12.30%

(b) Calculate the required rate of return for ABC Inc., assuming that investors expect a 3.0% rate of inflation in the future, the nominal risk-free rate is 4.5%, expected market return is 11% and the firm has a beta of 1.50.

Answer 1

Step-by-step explanation:

a.)

Given the different probabilities with their respective returns, you will find the firm's expected return using the following formula;

return; r = SUM (probability *expected return)

The formula above means that you multiply each probability by return , then sum the results.

r = (0.25*0.10) +(0.50*0.15) + (0.25*-0.02)

r = 0.025 +0.075 -0.005

r = 0.095 or 9.5%

Therefore, the correct answer is 9.5%. The choices given do not apply.

b.)

Use the Capital Asset Pricing Model(CAPM) formula to calculate the required return. Additionally, since we have inflation rate, adjust the formula to that inflation rate since investors would require a high rate to compensate for it.

Inflation adjusted CAPM required return; r = risk free + inflation + beta(Market return - risk free)

r = 0.045 + 0.03 + 1.50(0.11 - 0.045)

r = 0.075 + 0.0975

r = 0.1725 or 17.25%

Therefore, the required rate is 17.25%