Assume that the consensus required rate of return on common stocks is 14 percent. In addition you
QUESTION
Assume that the consensus required rate of return on common stocks is 14 percent. In addition, you read in Fortune that the expected rate of inflation is 5 percent and the estimated long-term real growth rate of the economy is 3 percent. What interest rate would you expect on U.S. government T-bills? What is the approximate risk premium for common stocks implied by these data?
Concept: Fisher equation represents the relation among nominal interest rate, inflation rate and real rate. (1+Nominal Interest Rate) = (1+Inflation Rate)*(1+Real Rate) According to CAPM Model: Required rate of Return = Rf + Beta*Risk Premium Where Rf -> Risk Free Rate (Interest Rate on U.S. Government T-bills) Rm -> Market Return (Average Stock) Solution: (a) Expected Rate of Inflation = 5% Real Growth Rate of the economy = 3% So, (1+Nominal Interest Rate of the economy) = (1+Inflation Rate)*(1+Real Growth
) = (1+5%)*(1+3%) Nominal Interest Rate of the economy = 8.15% Therefore, Expected Rate on U.S. government T-bills is 8.15%. (b) Market Beta = 1 Required rate of return on common stocks = 14% According to CAPM Model: 14% = 8.15% + 1*Market Risk Premium So, Market Risk Premium = 5.85% Therefore,approximate risk premium for common stocks is 5.85% .
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