Oakdale Furniture Inc.has a beta coefficient of 0.7 and a required rate of return of 15 percent.The market risk premium is currently 5 percent.If the inflation premium increases by 2 percentage points,and Oakdale acquires new assets which increase its beta by 50 percent,what will be Oakdale's new required rate of return?
A) 13.5%
B) 22.8%
C) 18.75%
D) 15.25%
E) 17.00%

Question

Quizplus · Accepted Answer

The original required rate of return is calculated using the Capital Asset Pricing Model (CAPM) formula: Required Return = Risk-Free Rate + (Beta * Market Risk Premium). Given that Oakdale's required return is 15% and its beta is 0.7 with a market risk premium of 5%, we can rearrange the formula to solve for the risk-free rate (Rf): 15% = Rf + (0.7 * 5%). Solving for Rf gives us 11.5%. If the inflation premium increases by 2 percentage points, the risk-free rate also increases by 2 percentage points (since the risk-free rate typically includes an inflation premium), making the new risk-free rate 13.5%. If Oakdale's beta increases by 50%, the new beta is 0.7 * 1.5 = 1.05. Plugging these new values into the CAPM formula gives us a new required rate of return: 13.5% + (1.05 * 5%) = 13.5% + 5.25% = 18.75%.