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chap011 - Solutions to Chapter 11 Risk Return and Capital...

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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 risk-free rate, not zero. c.False. The portfolio is invested one-third in Treasury bills and two-thirds 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. 11-1
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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 comparable-risk 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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