Solutions to Chapter 11
Risk, Return, and Capital Budgeting
1.
a.False.
Investors require higher expected rates of return on investments with high
market
risk, not high
total
risk.
Variability of returns is a measure of total risk.
b.
False.
If beta = 0, then the asset’s expected return should equal the riskfree rate,
not zero.
c.False.
The portfolio is invested onethird in Treasury bills and twothirds in the
market.
Its beta will be:
(1/3
×
0) + (2/3
×
1.0) = 2/3
c.
True.
e.True.
2.
The risks of deaths of individual policyholders are largely independent, and are therefore
diversifiable.
The insurance company is satisfied to charge a premium that reflects
actuarial probabilities of death, without an additional risk premium.
In contrast, flood
damage is not independent across policyholders.
If my coastal home floods in a storm,
there is a greater chance that my neighbor’s will too.
Because flood risk is not
diversifiable, the insurance company may not be satisfied to charge a premium that
reflects only the expected value of payouts.
3.
The actual returns for the Snake Oil fund exhibit considerable variation around the
regression line.
This indicates that the fund is subject to diversifiable risk: it is not well
diversified.
The variation in the fund’s returns is influenced by more than just market
wide events.
4.
Investors would buy shares of firms with high levels of diversifiable risk, and earn high
risk premiums.
But by holding these shares in diversified portfolios, they would not
necessarily bear a high degree of portfolio risk.
This would represent a profit
opportunity, however.
As investors seek these shares, we would expect their prices to
rise, and the expected rate of return to investors buying at these higher prices to fall.
This process would continue until the reward for bearing diversifiable risk dissipated.
5.
a.Required return = r
f
+
β
(r
m
– r
f
) = 4% + 0.6
×
(14% – 4%) = 10%
With an IRR of 14%, the project is attractive.
111
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b.
If beta = 1.6, then required return increases to:
4% + 1.6
×
(14% – 4%) = 20%
This is greater than the project IRR.
You should now reject the project.
c.Given its IRR, the project is attractive when its risk and therefore its required return are
low.
At a higher risk level, the IRR is no longer higher than the expected return on
comparablerisk assets available elsewhere in the capital market.
6.
a.The expected cash flows from the firm are in the form of a perpetuity.
The discount
rate is:
r
f
+
β
(r
m
– r
f
) = 4% + 0.4
×
(12% – 4%) = 7.2%
Therefore, the value of the firm would be:
89
.
888
,
138
$
072
.
0
000
,
10
$
r
flow
Cash
P
0
=
=
=
b.
If the true beta is actually 0.6, the discount rate should be:
r
f
+
β
(r
m
– r
f
) = 4% + 0.6
×
(12% – 4%) = 8.8%
Therefore, the value of the firm is:
36
.
636
,
113
$
088
.
0
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 Spring '08
 Park
 Capital Asset Pricing Model, Financial Markets, Net Present Value, Internal rate of return

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