PROBLEM 8-15

CAMP AND REQUIRED RETURN: AM Inc. has a beta of 1.4 and PM Inc. has a beta
of 0.7. The required market return is 16% and the risk-free rate is 7%. After a financial
crisis the expected rate of inflation built into risk-free rate falls by 2 percentage points
and the required market return falls to 12%. Other conditions do not change. What will be
the respective difference in the required returns for AM Inc. and PM Inc.?
ANSWER: Required Returns of AM Inc. decrease 4.8%
Required Returns of PM Inc. decrease 3.4%
GIVEN:
AM Inc.:
Beta = 1.4
Risk- free rate = 7%
Required Market Return = 16%
PM Inc.:
Beta = 0.7
Risk- free rate = 7%
Required Market Return = 16%
FORMULA:
Required Returns of AM Inc. = 7%+1.4(16%-7%) =19.6%
Required Returns of PM Inc. = 7%+0.7(16%-7%) =13.3%
After a financial crisis the expected rate of inflation built into risk-free rate falls by 2
percentage points:
New Risk-free = 7% – 2%
New Risk-free = 5%
The required market return falls to 12%:
Required Market Return = 12%

NEW Required Returns of AM Inc. = 5% + 1.4(12% – 5%) =14.8%

NEW Required Returns of PM Inc. = 5% + 0.7(12% – 5%) = 9.9%
Required Returns of AM Inc. = 19.6% - 14.8%
Required Returns of AM Inc. = 4.8%
Required Returns of PM Inc. = 13.3% - 9.9%
Required Returns of PM Inc. = 3.4%

Required Returns of AM Inc. decrease 4.8%

Required Returns of PM Inc. decrease 3.4%