Suppose the common stock of United Industries has a beta of 1.28 and an expected return of 15.47 percent. The risk-free rate of return is 3.7 percent while the inflation rate is 4.2 percent. What is the expected market risk premium?
A) 7.02 percent
B) 9.20 percent
C) 10.63 percent
D) 11.22 percent
E) 11.60 percent

Question

Quizplus · Accepted Answer

To solve for the expected market risk premium, we need to use the Capital Asset Pricing Model (CAPM) formula:

Expected Return = Risk-Free Rate + Beta * (Market Risk Premium)

We are given the following information:

Expected Return = 15.47%
Beta = 1.28
Risk-Free Rate = 3.7%
Inflation Rate = 4.2%

First, we need to adjust the expected return for inflation:

Real Return = (1 + Expected Return) / (1 + Inflation Rate) - 1

Real Return = (1 + 15.47%) / (1 + 4.2%) - 1
Real Return = 10.94%

Now we can use the CAPM formula to solve for the market risk premium:

Market Risk Premium = (Real Return - Risk-Free Rate) / Beta

Market Risk Premium = (10.94% - 3.7%) / 1.28
Market Risk Premium = 5.70%

Therefore, the expected market risk premium is 5.70%, which is closest to answer choice B (9.20%).

Suppose the Common Stock of United Industries Has a Beta