Question

HR Industries (HRI) has a beta of 1.4, while LR Industries's (LRI) beta is 0.8. 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

Inflation rate built into Risk Free rate falls by 1.5%

So new Risk Free rate = 6%-1.5% = 4.5%

New market Required Return = 10.5%

Required Return as per CAPM formula = Risk Free rate +(beta*(market Required Return - Risk Free rate))

Required Return of HRI = 4.5% +(1.4*(10.5%-4.5%))

=12.9%

Required return of LRI = 4.5% +(0.8*(10.5%-4.5%))

=9.3%

Difference between required return = 12.9%-9.3%

=3.6%

So difference between required return of HRI and LRI is 3.6%