Puritan Motors has a capital structure consisting almost entirely of equity.
a. If the beta of Puritan stock equals 1.6, the risk-free rate equals 6%, and the expected return on the market portfolio equals 11%, what is its cost of equity?
b. Suppose that a 1% increase in expected inflation causes a 1% increase in the risk-free rate. Holding all other factors constant, what will this do to the firm’s cost of equity? Is it reasonable to hold all other factors constant? What other part of the calculation of the cost of equity is likely to change if expected inflation rises?