Fundamentals of Corporate Finance + Standard & Poor's Educational Version of Market Insight

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Unformatted text preview: CHAPTER 7 Introduction to Risk, Return, and The Opportunity Cost of Capital Answers to Practice Questions 1. Recall from Chapter 3 that: (1 + r nominal ) = (1 + r real ) (1 + inflation rate) Therefore: r real = [(1 + r nominal )/(1 + inflation rate)] 1 a. The real return on the stock market in each year was: 1999: 20.4% 2000:-13.8% 2001:-12.4% 2002:-22.8 2003: 29.1% b. From the results for Part (a), the average real return was: 0.10% c. The risk premium for each year was: 1999: 18.9% 2000:-16.8% 2001:-14.8% 2002:-22.6% 2003: 30.6% d. From the results for Part (c), the average risk premium was: 0.94% e. The standard deviation ( ) of the risk premium is calculated as follows: [ 2 2 2 2 0.0094)) 0.148 ( 0094)) 0.168 ( 0.0094)) (0.189 1 5 1 --- +--- +-- - = ( . ( ( 0.057530 0.0094)) (0.306 0.0094)) 0.226 ( 2 2 =-- +--- + ] ( ( 23.99% 0.2399 0.057530 = = = 2. Internet exercise; answers will vary. 51 3. a. A long-term United States government bond is always absolutely safe in terms of the dollars received. However, the price of the bond fluctuates as interest rates change and the rate at which coupon payments received can be invested also changes as interest rates change. And, of course, the payments are all in nominal dollars, so inflation risk must also be considered. b. It is true that stocks offer higher long-run rates of return than do bonds, but it is also true that stocks have a higher standard deviation of return. So, which investment is preferable depends on the amount of risk one is willing to tolerate. This is a complicated issue and depends on numerous factors, one of which is the investment time horizon. If the investor has a short time horizon, then stocks are generally not preferred. c. Unfortunately, 10 years is not generally considered a sufficient amount of time for estimating average rates of return. Thus, using a 10-year average is likely to be misleading. 4. The risk to Hippique shareholders depends on the market risk, or beta, of the investment in the black stallion. The information given in the problem suggests that the horse has very high unique risk, but we have no information regarding the horses market risk. So, the best estimate is that this horse has a market risk about equal to that of other racehorses, and thus this investment is not a particularly risky one for Hippique shareholders. 5. In the context of a well-diversified portfolio, the only risk characteristic of a single security that matters is the securitys contribution to the overall portfolio risk. This contribution is measured by beta. Lonesome Gulch is the safer investment for a diversified investor because its beta (+0.10) is lower than the beta of Amalgamated Copper (+0.66). For a diversified investor, the standard deviations are irrelevant....
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chap07_newsol - CHAPTER 7 Introduction to Risk, Return, and...

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