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Risk and Return: Sample Problems

Maxwell Inc.'s expected stock return is 9.9% based on probabilities of different return outcomes. The coefficient of variation for Wei Inc.'s project is 1.2 based on its expected return and standard deviation. Bill Dukes' portfolio beta is 0.98 based on the betas and weights of the two stocks in his portfolio. Climax Inc.'s required rate of return using CAPM is 12% given information about risk-free rates, inflation, market risk premium, and its beta of 1.

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407 views14 pages

Risk and Return: Sample Problems

Maxwell Inc.'s expected stock return is 9.9% based on probabilities of different return outcomes. The coefficient of variation for Wei Inc.'s project is 1.2 based on its expected return and standard deviation. Bill Dukes' portfolio beta is 0.98 based on the betas and weights of the two stocks in his portfolio. Climax Inc.'s required rate of return using CAPM is 12% given information about risk-free rates, inflation, market risk premium, and its beta of 1.

Uploaded by

Rynette Flores
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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RISK AND RETURN

Sample Problems
EXPECTED RETURN
• Maxwell Inc.'s stock has a 50% chance of producing a 25% return, a 30%
chance of producing a 10% return, and a 20% chance of producing a -28%
return. What is the firm's expected rate of return?

• Answer:
• 9.90%
Prob.
• Conditions Prob. Return × Return
• Good 0.50 25.0% 12.50%
• Average 0.30 10.0% 3.00%
• Poor 0.20 -28.0% -5.60%
• 1.00 9.90% = Expected return
COEFFICIENT OF VARIATION
• Wei Inc. is considering a capital budgeting project that has an expected
return of 25% and a standard deviation of 30%. What is the project's
coefficient of variation?
• Answer:
• 1.20

• Expected return 25.0%


• Standard deviation 30.0%
• Coefficient of variation = Std dev/Expected return = 1.20
PORTFOLIO BETA
• Bill Dukes has P100,000 invested in a 2-stock portfolio. P35,000 is
invested in Stock X and the remainder is invested in Stock Y. X's beta is
1.50 and Y’s beta is 0.70. What is the portfolio's beta?
• Answer:
• 0.98
• Weight
• Company Investment Weight Beta × beta
• X P35,000 0.35 1.50 0.53
• Y P65,000 0.65 0.70 0.46
• P100,000 1.00 0.98
= Portfolio beta
CAPM
• Calculate the required rate of return for Climax Inc., assuming that (1)
investors expect a 4.0% rate of inflation in the future, (2) the real risk-free
rate is 3.0%, (3) the market risk premium is 5.0%, (4) the firm has a beta of
1.00, and (5) its realized rate of return has averaged 15.0% over the last 5
years.
• Answer:
• 12.00%
• Real rate (r*): 3.00%
• IP: 4.00%
• RPM: 5.00%
• Beta: 1.00
• Required return = rRF + b(RPM) = r* + IP + b(RPM) = 12.00%
EXPECTED RETURN (5 MINUTES)
• Permanent Inc.'s stock has a 25% chance of producing a
30% return, a 50% chance of producing a 12% return,
and a 25% chance of producing a -18% return. What is
the firm's expected rate of return?
COEFFICIENT OF VARIATION (5 MINUTES)
• Easy Inc. is considering an investment that has an
expected return of 15% and a standard deviation of
10%. What is the investment's coefficient of variation?
PORTFOLIO BETA (5 MINUTES)
• Mando Rugas has a 2-stock portfolio with a total value of
P100,000. P37,500 is invested in Stock A with a beta of
0.75 and the remainder is invested in Stock B with a beta
of 1.42. What is his portfolio’s beta?
CAPM (5 MINUTES)
• Good Company's stock has a beta of 1.40, the risk-free
rate is 4.25%, and the market risk premium is 5.50%.
What is the firm's required rate of return?
PORTFOLIO BETA (5 MINUTES)
• You hold a diversified $100,000 portfolio consisting of 20
stocks with $5,000 invested in each. The portfolio's beta
is 1.12. You plan to sell a stock with b = 0.90 and use the
proceeds to buy a new stock with b = 1.80. What will the
portfolio's new beta be?
ANSWERS
• 9.50%
• 0.67
• 1.17
• 11.95%
• 1.165
EXPECTED RETURN, SD, AND COV
• Champion Breweries must choose between two asset purchases. The
annual rate of return and related probabilities given below summarize
the firm's analysis.

• For each asset, compute


• (a) the expected rate of return.
15% and 15%
• (b)the standard deviation of the expected return. 3.87% and 8.94%
• (c) the coefficient of variation of the return. 0.26 and 0.60
• (d)Which asset should Champion select? Choose Asset A
• Tangshan Antiques has a beta of 1.40, the annual risk-free rate of interest
is currently 10 percent, and the required return on the market portfolio is
16 percent. The firm estimates that its future dividends will continue to
increase at an annual compound rate consistent with that experienced
over the 2000-2003 period.

• (a) Estimate the value of Tangshan Antiques stock.


• (b)A lawsuit has been filed against the company by a competitor, and the
potential loss has increased risk, which is reflected in the company's beta,
increasing it to 1.6. What is the estimated price of the stock following the
filing of the lawsuit.
• Tangshan China's stock is currently selling for P160.00 per share and the
firm's dividends are expected to grow at 5 percent indefinitely. In
addition, Tangshan China's most recent dividend was P5.50. The
expected risk free rate of return is 3 percent, the expected market return
is 8 percent, and Tangshan has a beta of 1.20.
• (a) What is the expected return based on the dividend valuation model?
• (b)What is the required return based on the CAPM?
• (c) Would Tangshan China be a good investment at this time? Explain

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