UGBA 103 _4.1 Answers - UGBA 103 Haas School of Business...

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UGBA 103 Summer 2010 Haas School of Business John Gonzales Assignment #4 Answers 2. (a) r S = 6.46 + 1.4(14 – 6.46) = 17.02%. P 0 = 2.16/(.1702 - .08) = $23.95. (b) Now, r S = [6.46 + 1.5] + 1.4[(14 + 1.5) – (6.46 + 1.5)] = 18.52%. The rate of return always includes compensation for inflation, so the rate of return must increase by 1.5%. Now, P 0 = 2.16/(.1852 - .08) = $20.53. Price decreases because any financial asset is worth less if inflation increases. Alternatively, the rate of return on bonds increases as market interest rates always increase if inflation increases. The return on stocks must increase if bond returns increase. A higher return on stocks can be achieved only if stock prices fall. (c) Now, r M = 13%, so r S = 6.46 + 1.4(13 – 6.46) = 15.62%. If investors become less risk averse regarding stocks, less compensation is required to hold stocks. So, r S decreases. Now, P 0 = 2.16/(.1562 - .08) = $28.35. Price increases because investors are now willing to pay more for stocks since they are viewed as being less risky. (d) The actual return must fall from 18.60% to 17.02%. In order to have a lower
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UGBA 103 _4.1 Answers - UGBA 103 Haas School of Business...

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