Nguyễn Hương Giang – 21051637

REVISION FOR THE CHAPTERS 4-6

Chapter 4

Review question

4.5 What is liquidity, and what is the rationale for its measurement?

- Liquidity is the ability to repay short-term debt on time.

- Liquidity is measured by two approaches:
 Comparing the firm’s current assets and current liabilities
 Examining the firm’s ability to convert accounts receivables and inventory
into cash on a timely basis.

4.8 What is the difference between a firm’s gross profit margin, operating profit margin,
and net profit margin?

 The gross profit margin measures the firm’s pricing decisions. Gross Margin =
Revenue minus Cost of Sales (basically: what you sell the product or service for
the customer, minus what it costs you to make or buy it). Shareholders
 The operating profit margin then adds the cost of distributing the product to the
customer. Operating Margin = Gross Margin minus Selling, General and
Administrative (SG&A) expenses, and minus Research and Development (R&D)
expenses (basically: the margin you make on the product or service, minus the
“back office” costs (sales, marketing, HR, finance, sourcing, etc.)).
 The net profit margin adds the firm's financing decisions to the operating
performance. Net Profit Margin = Operating Margin minus Interest, and minus
Taxes (basically: what is left over after deducting all expenses from revenue).
Debtor bank.

Solve problem

4.1 (Evaluating liquidity) Aylward Inc. currently has $2,145,000 in current assets and
$858,000 in current liabilities. The company’s managers want to increase the firm’s

inventory, which will be financed by a short-term note with the bank. What level of

inventories can the firm carry without its current ratio falling below 2.0?

Current Assets = $2,145,000

Current Liabilities = $858,000

Current Ratio = Current Assets / Current Liabilities

 Current Ratio = (Current Assets - Inventory) / Current Liabilities

 (Current Assets - Inventory) / Current Liabilities = 2.0

 (2,145,000 - Inventory) / 858,000 = 2.0

 2,145,000 - Inventory = 2.0 * 858,000

 2,145,000 - Inventory = 1,716,000

 Inventory = 2,145,000 - 1,716,000

 Inventory = $429,000

4.3 (Evaluating profitability) Last year, Stevens Inc. had sales of $400,000 with a cost of
goods sold of $112,000. The firm’s operating expenses were $130,000, and its increase in
retained earnings was $58,000. There are currently 22,000 common stock shares
outstanding and the firm pays a $1.60 dividend per share.

a. Assuming the firm’s earnings are taxed at 21 percent, construct the firm’s income
statement.

Taxes (21% Operating income)

Increase in RE = $58,000

Current common stock = 22,000 shares

Dividend = dividend per share * share outstanding

  Dividends = $1.60* 22,000 = 35,200

RE = Increase in Retained Earnings - Dividends = 22,800

Income statement:

400,00
Sales (revenue) 0
112,00
CoGS 0
288,00
Gross profit 0

130,00
Operating expense 0
158,00
Operating profit (EBIT) 0

Common stock 22,000

3
Dividend 5,200

Increase in Retained earning 58,000

2
RE 2,800
8
Interest expense 4,582
7
Earnings before taxes (EBT) 3,418
1
Taxes 5,418
 5
Net income 8,000

b. Compute the firm’s operating profit margin.

Operating profit margin = Operating income/ sales

Operating profit margin = $158,000/ $400,000 = 39,5%

c. What was the times interest earned?

Times Interest Earned = Operating Profits/ Interest Expense

= $158,000/ $84,582 = 1.867

4.6 (Ratio analysis) The balance sheet and income statement for the A. Thiel Mfg.
Company are as follows:
 Current Ratio = Current Assets / Current Liabilities

Current Assets = $3,500

Current Liabilities = $2,000

Current Ratio = $3,500 / $2,000 = 1.75

  Operating Return on Assets = Operating Profits / Total Assets

Operating Profits = $1,700

Total Assets = $8,000

Operating Return on Assets = $1,700 / $8,000 ≈ 0.2125 or 21.25%

 Times Interest Earned = Operating Profits / Interest Expense

Operating Profits = $1,700

Interest Expense = $367

Times Interest Earned = Operating Profits / Interest Expense

Times Interest Earned = $1,700 / $367 ≈ 4.63

 Debt Ratio = Total Liabilities / Total Assets

Total Liabilities = Current Liabilities + Long-term Debt = $2,000 + $2,000 = $4,000

Total Assets = $8,000

Debt Ratio = $4,000 / $8,000 = 0.5 or 50%

 Inventory Turnover = Cost of Goods Sold / Average Inventory

Cost of Goods Sold = $3,300

Average Inventory = (Beginning Inventory + Ending Inventory) / 2

Since the beginning inventory is not provided, we'll assume it is the same as the
ending inventory.

Average Inventory = $1,000

Inventory Turnover = $3,300 / $1,000 = 3.3

 Average Collection Period = Accounts Receivable / (Annual Credit Sales /

365)
 Accounts Receivable = $2,000

Annual Credit Sales = $8,000

Average Collection Period = $2,000 / ($8,000 / 365) ≈ 91.25 days or approximately

91 days

 Total Asset Turnover = Sales / Total Assets

Sales = $8,000

Total Assets = $8,000

Total Asset Turnover = $8,000 / $8,000 = 1

 Fixed-Asset Turnover = Sales / Net Fixed Assets

Sales = $8,000

Net Fixed Assets = $4,500

Fixed-Asset Turnover = $8,000 / $4,500 ≈ 1.78

 Operating Profit Margin = Operating Profits / Sales

Operating Profits = $1,700

Sales = $8,000

Operating Profit Margin = $1,700 / $8,000 ≈ 0.2125 or 21.25%

 Return on Equity = Net Income / Owners' Equity

Net Income = $1,053

Owners' Equity = $4,000

Return on Equity = $1,053 / $4,000 ≈ 0.2633 or 26.33%

4.7 (Analyzing operating return on assets) The D.A. Winston Corporation earned an
operating profit margin of 10 percent based on sales of $10 million and total assets of $5
million last year.

a. What was Winston’s total asset turnover ratio?

Total asset turnover ratio = Net sales / Average total assets

Total asset turnover ratio = $10 million / $5 million
Total asset turnover ratio = 2.0

b. During the coming year the company president has set a goal of attaining a total asset
turnover of 3.5. How much must firm sales rise, other things being the same, for the goal
to be achieved? (State your answer in both dollars and percentage increase in sales.)

Sales increase required to achieve a total asset turnover ratio of 3.5

To achieve a total asset turnover ratio of 3.5, Winston's sales need to increase to
$17.5 million. This is an increase of $7.5 million, or 75%.
 Required sales = Total assets * Total asset turnover ratio

Required sales = $5 million * 3.5

Required sales = $17.5 million

 Sales increase = Required sales - Current sales

Sales increase = $17.5 million - $10 million

Sales increase = $7.5 million

 Sales increase percentage = (Sales increase / Current sales) * 100%

Sales increase percentage = ($7.5 million / $10 million) * 100%

Sales increase percentage = 75%

c. What was Winston’s operating return on assets last year? Assuming the firm’s
operating profit margin remains the same, what will the operating return on assets be next
year if the total asset turnover goal is achieved?

Operating profit = Operating profit margin*Net sales

Operating profit = 10%* $10 million = 1 million

ROA = Operating profit / Average total assets

ROA = $1 million / $5 million

ROA = 0.20, or 20%

Operating return on assets (ROA) next year. Assuming Winston's operating profit
margin remains the same, the company's ROA will be 17.5% next year if the total
asset turnover goal is achieved.
 ROA next year = Operating profit margin * Total asset turnover ratio
ROA next year = 0.10 * 3.5
ROA next year = 0.35, or 35%

4.8 (Evaluating liquidity) The Tabor Sales Company had a gross profit margin (gross
profits ÷ sales) of 30 percent and sales of $9 million last year. Seventy-five percent of the
firm’s sales are on credit and the remainder are cash sales. Tabor current assets equal $1.5
million, its current liabilities equal $300,000, and it has $100,000 in cash plus marketable
securities.

a. If Tabor’s accounts receivable are $562,500, what is its average collection period?

ACP = (Account receivables/Days in credit sales)

ACP = ($562,500/ (0/75*$9,000,000))*365
ACP= 30.4

b. If Tabor reduces its days in receivable (average collection period) to 20 days, what will
be its new level of accounts receivable?
 New level of accounts receivable = (New average collection period / 365) * Credit
sales
New level of accounts receivable = (20/365)*(0.75*$9,000,000) = $369,863

c. Tabor’s inventory turnover ratio is 9 times. What is the level of Tabor’s inventories?

Inventory turnover = (CoGS/Inventory) = 9

Gross profit margin = (Gross profit/ Sales) = ((Sales-CoGS)/Sales) = 0.3

 1- (CoGS/Sales) = 0.3
 CoGS/Sales = 0.7
 Inventory = 700

4.16 (Computing ratios) Use the information from the balance sheet and income
statement below to calculate the following ratios:

Current ratio Days in receivables

Acid-test ratio Operating return on assets

Times interest earned Debt ratio

Inventory turnover Return on equity

Total asset turnover Fixed asset turnover

Operating profit margin

1. Current Ratio:
Current Ratio = Current Assets / Current Liabilities
Current Assets = $190,000
Current Liabilities = $153,000
Current Ratio = $190,000 / $153,000 ≈ 1.24
2. Days in Receivables:
Days in Receivables = (Accounts Receivable / (Annual credit sales/ 365))
 Accounts Receivable = $30,000
Sales = $210,000
Days in Receivables = ($30,000/(0.88*$210,000)/365) ≈ 59.253 days or
approximately 59 days
3. Acid-Test Ratio
Acid test ratio = (cash+ accounts receivable)/ Current Liabilities
Cash = $100,000
Account receivable = $30,000
Current Liabilities = $153,000
Acid-Test Ratio = ($100,000 + $30,000) / $153,000 ≈ 0.85
4. Operating Return on Assets

Operating Return on Assets = Operating Profits / Total Assets

Operating Profits = $65,000

Total Assets = $525,000

Operating Return on Assets = $65,000 / $525,000 ≈ 0.124 or 12.4%

5. Times Interest Earned

Times Interest Earned = Operating Profits / Interest Expense

Operating Profits = $65,000

Interest Expense = $8,000

Times Interest Earned = $65,000 / $8,000 = 8.125

6. Debt Ratio

Debt Ratio = Total Debt / Total Assets

Total Debt = Total Current Debt + Long-term Debt = $153,000 + $120,000 =

$273,000
 Total Assets = $525,000

Debt Ratio = $273,000 / $525,000 ≈ 0.52 or 52%

7. Inventory Turnover

Inventory Turnover = Cost of Goods Sold / Average Inventory

Cost of Goods Sold = $90,000

Average Inventory = (Beginning Inventory + Ending Inventory) / 2

Since the beginning inventory is not provided, we'll assume it is the same as the
ending inventory.

Average Inventory = $50,000

Inventory Turnover = $90,000 / $50,000 = 1.8

8. Return on Equity

Return on Equity = Net Income / Shareholders' Equity

Net Income = $41,000

Shareholders' Equity = Common Stock + Retained Earnings = $205,000 + $47,000

= $252,000

Return on Equity = $41,000 / $252,000 ≈ 0.163 or 16.3%

9. Total Asset Turnover

Total Asset Turnover = Sales / Total Assets

Sales = $210,000

Total Assets = $525,000

Total Asset Turnover = $210,000 / $525,000 ≈ 0.4

10. Fixed Asset Turnover

 Fixed Asset Turnover = Sales / Net Fixed Assets

Sales = $210,000

Net Fixed Assets = Gross Plant and Equipment - Accumulated Depreciation

Net Fixed Assets = $401,000 - $66,000 = $335,000

Fixed Asset Turnover = $210,000 / $335,000 ≈ 0.627 or 62.7%

11. Operating Profit Margin

Operating Profit Margin = Operating Profits / Sales

Operating Profits = $65,000

Sales = $210,000

Operating Profit Margin = $65,000 / $210,000 ≈ 0.31 or 31%

Chapter 5

Review question

5.3 How would an increase in the interest rate (r) or a decrease in the holding period (n)
affect the future value (FVn) of a sum of money? Explain why

FVn = PV(1 + r)^n

Where: PV is the present value of the sum of money

r is the interest rate

n is the holding period

 An increase in r will increase FVn, and a decrease in n will decrease FVn.

5.4 Suppose you were considering depositing your savings in one of three banks, all of
which pay 5 percent interest; bank A compounds annually, bank B compounds
semiannually, and bank C compounds daily. Which bank would you choose? Why?
 - Bank C, which compounds daily, pays the highest interest. This occurs because,
while all banks pay the same interest, 5 percent, bank C compounds the 5 percent
daily. Daily compounding allows interest to be earned more frequently than
semiannual or annual compounding. Continuous compounding (not included with
this question) allows interest to be earned more frequently than any other
compounding period.

5.5 What is an annuity? Give some examples of annuities. Distinguish between an

annuity and a perpetuity.

- An annuity is a series of equal dollar payments for a specified number of years.

Examples of annuities are regular deposits to a savings account, monthly home
mortgage payments, monthly insurance payments, and pension payments.
- A perpetuity is an annuity that continues forever
- The primary difference between annuities and perpetuities lies in the period of
payments. Annuities have a defined duration, while perpetuities continue
indefinitely. Another difference is the payment structure. Annuities usually have
fixed or variable payment amounts, whereas perpetuities offer a fixed payment
amount for each period.

Solve problem

5.7 (Future value) Sarah Wiggum would like to make a single investment and have $2
million at the time of her retirement in 35 years. She has found a mutual fund that will
earn 4 percent annually. How much will Sarah have to invest today? If Sarah were a
finance major and learned how to earn a 14 percent annual return, how much would she
have to invest today?

FV = $2.2 million

Interest rate = 4%

Number of years = N = 40
 Sarah wants to invest an amount today so that she accumulates $2 million by the
time she retires. Thus, $2 million can be thought of as the future value (FV) of the
amount invested. Thus, the amount that Sarah needs to invest today can be
calculated using the formula for the FV of a single cash flow:

FV = PV (1 + Interest rate)^n

⇔ $2 million = PV * (1 + 4%)^35 = PV * 3.946

=> PV = 506,842

=> Sarah needs to invest $506,842 to accumulate $2 million in 35 years.

If Sarah can earn a 14% return on this investment, Sarah will be able to accumulate
the required amount in a lower period. This, period can be calculated using the
following formula:

FV = PV*(1 + Interest rate)^n

⇔ $2 million = $506,842 ( 1+14%)^n

⇔ 3.946 = (1.14)^n

⇔ n = 10.476

=> Number of years = 10.5

Thus, if Sarah can earn a 14% return, she will be able to retire in 10.5 years, which
is (35 - 10.5) = 24.5 years earlier than the previous retirement period.

5.10 (Solving for r in compound interest) If you were offered $1,079.50 ten years from
now in return for an investment of $500 currently, what annual rate of interest would you
earn if you took the offer?

FV = PV(1+r) ^n

 1,079.50= 500(1+r) ^10 => r = 8%

5.23 (Solving for Present Value with Annuities) Nicki Johnson, a sophomore mechanical
engineering student, receives a call from an insurance agent, who believes that Nicki is an
older woman ready to retire from teaching. He talks to her about several annuities that
she could buy that would guarantee her an annual fixed income. The annuities are as
follows:

PV = PMT*((1-(1+r)-n)/r)

Annual rate A = 13.133%

Annual rate B = 10.760%

Annual rate C = 9.602%

 Choose A

5.24 (Loan amortization) Mr. Bill S. Preston, Esq., purchased a new house for $80,000.
He paid $20,000 down and agreed to pay the rest over the next 25 years in 25 equal end-
of-year payments plus 9 percent compound interest on the unpaid balance. What will
these equal payments be?

P = (PV * r) / (1 - (1 + r)^(-n))

PV = $80,000 - $20,000 = $60,000

r = 0.09

n = 25 years

P = (PVr(1+r)^n)/(((1+r)^n) -1)
 P = 6,108

=> So the equal end-of-year payments that Mr. Bill S. Preston, Esq., needs to make is
$6,108

5.31 (Compound annuity) You plan on buying some property in Florida 5 years from
today. To do this, you estimate that you will need $20,000 at that time for the purchase.
You would like to accumulate these funds by making equal annual deposits in your
savings account, which pays 12 percent annually. If you make your first deposit at the
end of this year, and you would like your account to reach $20,000 when the final deposit
is made, what will be the amount of your deposits?

FV = $20,000

r = 0.12

n=5

P = FV * (r / [(1 + r)^n - 1])

P = $20,000 * (0.12 / [(1 + 0.12)^5 - 1])

P ≈ $20,000 * 0.1574

P ≈ $3,148.2

 Therefore, to accumulate $20,000 in 5 years with annual deposits, you would need
to make equal annual deposits of approximately $3,148.2

5.49 (Calculating the effective annual rate) You’ve just received an offer from a bank for
a credit card with a quoted rate, or APR, of 18 percent compounded monthly. What’s the
EAR, or effective annual rate, on the credit card?

EAR = (1+APR/m)m -1 = (1+ (0.18/12))12 ) – 1 = 19.5

5.50 (Calculating an APR and EAR) You’re in need of some money fast, and rather than
ask your folks for help, you’ve decided to look into a payday loan. At a payday loan shop
right near your school you see that you can borrow $100 and repay $115 in 10 days.
What are the APR and the EAR on this payday loan?

APR = (Interest change/Principal) * (365/loan term) * 100

APR = 15/100 * 365/10 * 100
APR = 547.5%
EAR = (1+ (APR/n))n – 1
EAR = (1+ (547.5%/36.5))36.5 – 1
EAR = 16323.7%

Chapter 6

Review question

6.1 a. What is meant by the investor’s required rate of return?

An investor's required rate of return is the minimum rate of return necessary to

attract an investor to purchase or hold a security.

b. How do we measure the riskiness of an asset?

Risk is the potential variability in returns on an investment. Thus, the greater the
uncertainty as to the exact outcome, the greater the risk. Risk may be measured in
terms of the standard deviation of rates of return or by the variance of rates of
return, which is simply the standard deviation squared.

c. How should the proposed measurement of risk be interpreted?

A large standard deviation of the returns indicates greater riskiness associated with
an investment. Future cash flows have a greater potential variation. However,
whether the standard deviation is large relative to the returns has to be examined in
other investment opportunities. Alternatively, probability analysis is a meaningful
approach to capture a greater understanding of the significance of a standard
 deviation figure. However, we have chosen not to incorporate such an analysis
into our explanation of the valuation process.

6.2 What is (a) unsystematic risk (company-unique or diversifiable risk) and (b)
systematic risk (market or nondiversifiable risk)?

a. Unique risk is the variability in a firm's stock price that is associated with the
specific firm and not the result of some broader influence. An employee strike is
an example of a company-unique influence.
b. Systematic risk is the variability in a firm's stock price that is the result of general
influences within the industry or resulting from overall market or economic
influences. A general change in interest rates charged by banks is an example of
systematic risk.

6.3 What is a beta? How is it used to calculate r, the investor’s required rate of return?

- Beta indicates the responsiveness of a security's return to changes in the market

return. According to the CAPM, beta is multiplied by the market risk premium and
added to the risk-free rate of return to calculate the required rate of return.

6.4 What is the security market line? What does it represent?

- The security market line is a graphical representation of the risk-return trade-off

that exists in the market. The line indicates the minimum acceptable rate of return
for investors given the level of systematic risk of a security.

6.5 How do we measure the beta of a portfolio?

- The beta for a portfolio is equal to the weighted average of the betas of individual
stocks, weighted by the percentage invested in each stock.

6.6 If we were to graph the returns of a stock against the returns of the S&P 500 Index,
and the points did not follow a very ordered pattern, what could we say about that stock?
If the stock’s returns tracked the S&P 500 returns very closely, then what could we say?
 - If a stock has a great amount of variability about its characteristic line (the line of
best fit in the graph of the stock's returns against the market's returns), then it has a
high amount of unsystematic or company-unique risk. If, however, the stock's
returns closely follow the market movements, then there is little unsystematic risk.

6.7 Over the past eight decades, we have had the opportunity to observe the rates of
return and the variability of these returns for different types of securities. Summarize
these observations.

- Data have been compiled by Ibbotson Associates, Inc. on the actual returns for the
following portfolios of securities, plus the inflation rate, from 1926 to 2014.
1. Common stocks of large firms
2. Common stocks for small firms
3. Corporate bonds
4. Intermediate U.S. government bonds
5. U.S. Treasury bills
- Investors historically have received greater returns for greater risk-taking except
the U.S. government bonds. All portfolios generated returns that exceeded the
inflation rate. The portfolio that, on average, has consistently generated the highest
rate of return has been a portfolio made up of common stocks.

6.8 What effect will diversifying your portfolio have on your returns and your level of
risk?

- Through diversification, we can potentially accomplish one of two results: (1) We

can decrease the variability in returns without lowering the expected rate of return
of the portfolio, or (2) we can increase the expected rate of return without
increasing the variability in returns. The extent of these effects is in part
determined by the types of assets in the portfolio. For instance, diversification has
a greater effect when investing in different types of assets, such as government
securities and stocks, rather than just investing in different stocks.
Solve Problem

6.3 (Expected rate of return and risk) Carter, Inc. is

evaluating a security. Calculate the investment’s expected
return and its standard deviation.

Expected return = (0.15*6%) + (0.3*9%) + (0.4*10%) + (0.15*15%)

Expected return = 0.9% + 2.7% + 4% + 2.25%

Expected return = 9.85%

(S.D)2 = (6%-9.85%)2 + (9%-9.85%)2 + (10%-9.85%)2 + (15%-9.85%)2

(S.D)2 = 6.43

=> S.D = √ (6.43) = 2.54

6-10. (Computing holding-period returns)

a. From the price data here, compute the holding-period returns for Jazman and

Solomon for periods 2 through 4.

Holding-period return = (Ending price - Beginning price) / Beginning price * 100

For Jazman:

Period 2: (11 - 9) / 9 * 100 ≈ 22.22%

Period 3: (10 - 11) / 11 * 100 ≈ -9.09%

 Period 4: (13 - 10) / 10 * 100 ≈ 30.00%

For Solomon:

Period 2: (28 - 27) / 27 * 100 ≈ 3.70%

Period 3: (32 - 28) / 28 * 100 ≈ 14.29%

Period 4: (29 - 32) / 32 * 100 ≈ -9.38%

b. How would you interpret the meaning of a holding-period return?

The holding period return represents the percentage change in the value of an
investment over a specific holding period. It measures the return or profit earned (or loss
incurred) by an investor during that period relative to the initial investment.

For example, if the holding-period return is positive, such as 22.22% for Jazman in
period 2, it indicates that the investment increased in value by approximately 22.22%
during that period. This implies a profit or gain for the investor.

On the other hand, if the holding-period return is negative, like -9.09% for Jazman
in period 3, it suggests that the investment decreased in value by approximately 9.09%
during that period. This implies a loss for the investor.

6.14 (Expected return, standard deviation, and capital asset pricing model) The following
are the end-of-month prices for both the Standard & Poor’s 500 Index and Nike’s
common stock.
a. Using the data here, calculate the holding-period returns for each of the months.
Nike:
Jan = N/A July = 0.08%
Feb = 8.05% Aug = - 10.57%
March = (55.73 – 57.16)/ 57.16 = -2.5% Sep = - 1.82 %
April = - 0.75% Oct = 9.87%
May = - 4.37% Nov = 3.53%
June = 11.34% Dec = 9.06%
S&P 500: 2018.Jan = 9.06%

Jan = No answer
Feb = (2364-2279)/2279 = 3.73%
Mar = -0.04%
Apr = 0.89%
May = 1.17%
June = 0.46%
July = 1.94%
Aug = 0.08%
 Sep = 1.90%
Oct = 2.22%
Nov = 2.83%
Dec = 0.98%
2018 Jan = 5.61%
b. Calculate the average monthly return and the standard deviation for both the S&P
500 and Nike.

Nike = (8.05% - 2.5% - 0.57% - 4.37% + 11.34% + 0.08% - 10.57% -1.82% + 6.06%
+ 9.87% + 3.53% + 9.87% + 3.53% + 9.06%)/ 12

Nike = 2.35%

S&P500 = 1.81%

c. Develop a graph that shows the relationship between the Nike stock returns and
the S&P 500 Index. (Show the Nike returns on the vertical axis and the S&P 500
Index returns on the horizontal axis as done in Figure 6-5.)
 d. From your graph, describe the nature of the relationship between Nike stock
returns and the returns for the S&P 500 Index.

Nike return are more wridely distributed than S&P500

6.17 (Security market line)

a. Determine the expected return and beta for the following portfolio:

ER = 0.12*0.4 + 0.25*0.11 + 0.35*0.15

ER = 12.8%

Beta = 0.4*1 + 0.25*0.75 + 0.35*1.3

Beta = 1.0425

b. Given the foregoing information, draw the security market line and show where the
securities and portfolio fit on the graph. Assume that the riskfree rate is 2 percent and that
the expected return on the market portfolio is 8 percent. How would you interpret these
findings?

CAPM:

Ri = RF + β*(RM-RF)

Ri = 2% + β*(8%-2%)

If β = 0 => Ri = 2%

If β = 1 => Ri = 8%

=> SML
 Sercurity dense with β = 1.0425 and ER = 12 below SML as overated

6.23 (Portfolio beta and security market line) You own a portfolio consisting of the
stocks below:

The risk-free rate is 3 percent. Also, the expected return on the market portfolio is 11
percent.
a. Calculate the expected return of your portfolio. (Hint: The expected return of a
portfolio equals the weighted average of the individual stocks’ expected returns, where
the weights are the percentage invested in each stock.)

Expected return = (0.2*12%) + (0.3*8%) + (0.15*12%) + (0.25*7%) + (0.1*16%)

Expected return = 9.95%

b. Calculate the portfolio beta.

β = (0.2*1) + (0.3*0.85) + (0.15*1.2) + (0.25*0.6) + (0.1*1.6)

β = 0.945

c. Given the foregoing information, plot the security market line on paper. Plot the stocks
from your portfolio on your graph.

Ri = RF+β x (RM-RF)

RM = 3%

RF = 11%

d. From your plot in part (c), which stocks

appear to be your winners and which ones appear to be your losers?

Stocks 3 and 5 appear to be winners (above the SML). Stocks 1, 2 and 4 appear to
be losers (below the SML).

e. Why should you consider your conclusion in part (d) to be less than certain?

This conclusion is uncertain because the SML assumes perfect capital markets. In
reality, individual stock performance may differ from expectations due to factors not
captured by beta like management quality, product competition, etc. The plot only
provides an approximate assessment based on risk-return assumptions of the SML.