FIN 500: Case Study 1 Assignment
Notes
Your first case assignment deals with the concepts of risk and return. Please read the
case questions through and give some thought to your answers before you commence.
Answer all parts of the ten (10) questions presented below. Your report should be wellorganized, type-written/word processed, and independently prepared. Each student's
report must be his/her own original work and the write-up must also be individually
prepared.
1.
Buxton Corporation is planning to invest in a security that has several potential rates of
return. Using the following probability distribution of returns during different states of
the economy, what is the expected rate of return on this investment? In addition,
compute the standard deviation of the returns (σ). Finally, briefly explain what these
numbers represent.
Probability
0.10
0.20
0.30
0.40
2.
Expected Return
-10%
5%
10%
25%
Using the capital asset pricing model (CAPM), estimate the appropriate required rate of
return for the following three stocks, assuming that the risk-free rate (r RF) is 5 percent
and the expected return for the market (rM) is 17 percent.
Stock
A
B
C
3.
Based on the following table of actual (or ex post) returns for both Inquiry Corporation
and the market from 2007 through 2010, calculate the average return and the standard
deviation for both Inquiry and the market (keep in mind that this data is historical and
not based on a probability distribution, so be sure to use the correct formulas).
Year
2007
2008
2009
2010
4.
Beta (β)
0.75
0.90
1.40
Inquiry Corporation
4%
6%
0%
2%
Market
2%
3%
1%
-1%
(a)
Derive the expected return (rP) and beta (βP) for a portfolio based on the
following information:
Stock
Percentage of
Portfolio
40%
25%
35%
1
2
3
(b)
5.
Beta (β)
1.00
0.75
1.30
Expected
Return
12%
11%
15%
Given the information in the table above, present the equation for the security
market line and explain where the return for this specific portfolio would lie (plot)
relative to the SML (i.e., below or above the line). Assume that the risk-free rate
(rRF) is 8 percent and that the expected return on the market portfolio (r M) is 12
percent.
Reliable Printing is evaluating a security. One-year Treasury bills (r RF) are currently
paying 3.1 percent. Calculate the following investments expected return and its
standard deviation (σ). Should Reliable Printing invest in this security? Briefly explain.
Probability
0.15
0.30
0.40
0.15
Expected Return
-1%
2%
3%
8%
6. You have researched the common stock of two companies (A and B) and have
compiled the following information:
COMPANY A
Probability
0.20
0.50
0.30
COMPANY B
Return
Probability
-2%
0.10
18%
0.30
27%
0.40
0.20
Return
4%
6%
10%
15%
Calculate the expected return, standard deviation (σ), and the coefficient of variation
(CV) for each stock and, based on the CV, which stock should you invest in? Briefly
explain.
7. Assume you own a portfolio consisting of the following stocks:
Stock
1
2
3
Percentage of
Portfolio
20%
30%
15%
Beta (β)
1.00
0.85
1.20
Expected
Return
16%
14%
20%
4
5
25%
10%
0.60
1.60
12%
24%
(a) Determine the expected return on your portfolio.
(b) Determine the portfolio beta (βP).
(c) Given the portfolio beta and the assumptions that the risk-free rate (r RF) is 7 percent
and the expected return on the market portfolio (rMKT) is 15.5 percent, present the
equation for the security market line (SML).
(d) Based on your equation for the SML and the expected returns from the data in the
table, which stocks appear to be winners (i.e., underpriced) and which stocks
appear to be losers (i.e., overpriced)?
8.
The common stock for a particular company is known to have a beta (β) of 1.20. The
expected return on the market (rM) is 9 percent and the risk-free rate (rRF) is 5 percent.
(a) Compute a fair rate of return based on this information.
(b) What would be a fair rate of return if the beta were 0.85?
(c) What would be a fair rate of return if the expected return on the market increased to
12 percent and the beta remained at 0.85?
9.
The expected return for the general market (rMKT) is 12.8 percent, and the market risk
premium (i.e., RPM) is 4.3 percent. Moe, Larry, and Curley have betas of 0.82, 0.57,
and 0.68, respectively. What are the required rates of return for the three securities?
10.
Hickory Sticks common stock has a beta (β) of 0.95. The expected return for the
market (rM) is 7 percent and the risk-free rate (rRF) is 4 percent.
(a) What is the required rate of return based on this information?
(b) What would be the required rate of return if the beta were 1.25?
11. An exhaustive financial analysis has produced the following returns on two investments
under three different scenarios:
Scenario
S1
S2
S3
Expected Returns
Probability
0.3
0.4
0.3
Stock X
10%
16%
12%
Stock Y
8%
15%
20%
(a) Calculate the expected return on each investment.
(b) Calculate the standard deviations (σ) for both X and Y.
(c) Calculate the coefficient of variation (CV) for both X and Y.
(d) If you were to create a portfolio consisting of 67% of Stock X and 33% of Stock Y,
what will be the expected return (rP) and the standard deviation (σP) for your
portfolio?
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