Question

Suppose two factors are 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 6%. A stock with a beta of 1 on IP and .4 on IR currently is expected to provide a rate of return of 14%. If industrial production actually grows by 5%, while the inflation rate turns out to be 7%, what is your best guess for the rate of return on the stock?

Short answer

The correct answer = 15.4%

Step-by-step solution

Given Information

Old rate of return = 14%

Unexpected changes in factors = 1 and 0.4

Sensitivity coefficients = 1

Solution

The revised estimate of the expected rate of return of the stock would be the old estimate plus the sum of the unexpected changes in the factors times the sensitivity coefficients, as follows:

Revised estimate = 14% + [(1 x 1) + (0.4 x 1)] = 15.4%