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Calculate the required rate of return for Mercury Inc., assuming that investors expect a 5% rate of inflation in the future. The real risk-free rate is 3% and the market risk premium is 5%. Mercury has a beta of 2.0, and its realized rate of return has averaged 15% over the last 5 years. a. 20% b. 17% c. 18% d. 16% e. 15%

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Answer:

Option C is correct.

The required rate of return for Mercury Inc., assuming that investors expect a 5% rate of inflation in the future is 18%.

Explanation:

Real risk free rate = 3%

Inflation Premium = 5%

Nominal risk free rate Rf = Real risk free rate + Inflation Premium = 3% + 5% = 8%

Market risk premium (Rm –Rf) = 5%

Beta = 2

As per CAPM, required rate of return = Rf + beta * (Rm – Rf) = 8% + 2 * 5% = 18%

abiolataiwo2015

The required rate of return for Mercury Inc., assuming that investors expect a 5% rate of inflation in the future is: c. 18%.

First step is to calculate the Risk free rate (rRf)

Risk free rate (rRf) = Real risk free rate + Inflation Premium

Risk free rate (rRf) = 3% + 5%

Risk free rate (rRf)  = 8%

Second step is to calculate required rate of return (rs)

Required rate of return(rs)=8% + (5%)2.0

Required rate of return(rs)=8% +10%

Required rate of return(rs)=18%

Inconclusion the required rate of return for Mercury Inc., assuming that investors expect a 5% rate of inflation in the future is: c. 18%.

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