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The SML line can change due to expected inflation and risk aversion
The SML line can change due to expected inflation and risk aversion. If inflation changes, then the SML plotted on a graph will shift up or down parallel to the old SML. If risk aversion changes, then the SML plotted on a graph will rotate up or down becoming more or less steep if investors become more or less risk averse. A firm can influence market risk (hence its beta coefficient) through changes in the composition of its assets and through changes in the amount of debt it uses.
Quantitative Problem: You are given the following information for Wine and Cork Enterprises (WCE):
rRF = 4%; rM = 10%; RPM = 6%, and beta = 1.4
What is WCE's required rate of return? Do not round intermediate calculations. Round your answer to two decimal places.
If inflation increases by 3% but there is no change in investors' market risk premium, what is WCE's required rate of return now? Do not round intermediate calculations. Round your answer to two decimal places.
Assume now that there is no change in inflation, but market risk premium increases by 2%. What is WCE's required rate of return now? Do not round intermediate calculations. Round your answer to two decimal places.
If inflation increases by 3% and market risk premium increases by 2%, what is WCE's required rate of return now? Do not round intermediate calculations. Round your answer to two decimal places.
Expert Solution
Computation of the required rate of return:-
Required rate of return = rRF + (Beta*RPM)
= 4% + (1.4 * 6%)
= 4% + 8.40%
= 12.40%
Computation of the required rate of return:-
If inflation increases by 3%, then risk free rate = 4% + 3% = 7%
Required rate of return = rRF + (Beta*RPM)
= 7% + (1.4 * 6%)
= 7% + 8.40%
= 15.40%
Computation of the required rate of return:-
If market risk premium increases by 2%, then market risk premium = 6% + 2% = 8%
Required rate of return = rRF + (Beta*RPM)
= 4% + (1.4 * 8%)
= 4% + 11.20%
= 15.20%
Computation of the required rate of return:-
If inflation increases by 3% and market risk premium increase by 2%, then ;
Risk free rate = 4% + 3% = 7%
Market risk premium = 6% + 2% = 8%
Required rate of return = rRF + (Beta*RPM)
= 7% + (1.4 * 8%)
= 7% + 11.20%
= 18.20%
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