Module 3 - FILMORE ENTERPRISES -

Questions
1. Calculate the expected rate of return for each of the financial assets
listed in Table 1, and complete the expected return row for Table 1.
Based solely on the expected returns, which of the investments appears
the best and worst? Discuss the impact on returns for general changes in
the economy for CPC, Morely, and EAT.
2. Considering U.S. Treasuries are guaranteed by the U.S. government,
answer the following questions.
a. Is the T-bill return independent of the state of the economy? Briefly
explain. Do T-bills promise completely risk-free returns? Explain.
Yes, T-bills give a fixed return that is not adjusted according
to external factors. There is some risk in T-Bills; for example,
the government may default or dissolve.
b. Why do T-bond returns vary? Why are T-bond returns high when the
market returns are low?
Returns vary because interest rates determine bond rates.
c. How would returns on corporate bonds that Filmore Enterprises
might issue compare with those for T-bonds? Would your answer be
dependent on the potential bond rating of Filmore Enterprises?
Usually, corporate bonds are considered riskier and therefore
have higher returns. However, depending on Filmore
Enterprises bond rating, T bonds may have a higher return.
3. Basing a decision solely on expected returns is appropriate only for risk-
neutral individuals. Since most people are risk averse, risk is an
important consideration for the decision.
a. Two possible measures of risk are the standard deviation and the
coefficient of variation. Calculate the standard deviation and
coefficient of variation for CPC returns and complete the related
blanks in Table 1.
 The standard deviation for CPC is 22.29%. The coefficient of
variation is 2.42.
b. Compare the risk and expected return relationships among all six
assets listed in Table 1. Explain the apparent discrepancies with the
normal risk and return tradeoff.
Morley’s risk-return tradeoff is not apparent. The stock has a
standard deviation twice that of T-Bonds, but has a lower
return.
4. Suppose investors create a 2-stock portfolio by investing $100,000 in
CPC and $100,000 in Morely.
a. Calculate the expected return for each state of the economy, and then
compute the expected return for the portfolio. Complete the related
blank in Table 2.
b. Compute the standard deviation for the portfolio, and compare it to
the standard deviation of the individual stocks. Complete the related
blanks in Table 2.
c. In general, how would risk be affected if you formed another portfolio
composed of CPC and EAT? Explain how the correlation coefficient
affects the level of diversification in the CPC-Morely and the CPC-
EAT portfolios.
` The standard deviation would be affected depending on the
funds allocated to each portfolio. For example, if more funds
were composed of CPC, the standard deviation would be
closer to 22.29%. If more funds were composed of EAT, the
standard deviation would be closer to 17.81%. Correlation of
the two stocks also matters. If there is a positive correlation,
the two stock move together, increasing possible losses. If the
two stocks are negatively correlated, risk is reduced.
d. Explain what would happen to the expected return and standard
deviation as the portfolio mix changes. If you are using the spread-
sheet model for the case, determine the expected return and standard
deviation for a series of CPC-Morely portfolios starting with 0% CPC
and increasing the percentage by 10 points for each iteration.
The expected return and standard deviation of a portfolio
depend on the amount of the portfolio invested into each
 individual stock. The weights of the investment will then be
accounted for the actual standard deviation and return of the
portfolio.
5. Suppose an investor has a portfolio consisting of just one randomly-
selected stock. What happens to the risk as the investor adds more and
more randomly-selected stocks to the portfolio? Illustrate your answer
with a graph showing “portfolio standard deviation” on the vertical axis
and “number of stocks” on the horizontal axis.

Portfolio Standard Deviation

8
7
6
5
4 Portfolio Standard
3 Deviation

2
1
0
1 Security 2 Securities 3 Securities 4 Securities

6. Answer the following questions relating to diversification.

a. What implication does diversification have for investors?
To investors, diversication usually means a reduction of risk.
It will retain returns, but reduce the level of risk in a
portfolio.
b. If an investor decides to hold a 1-stock portfolio and as a result is
exposed to more risk than diversified investors, could the non-
diversified investor expect to be compensated for all his or her risk?
That is, could the investor earn a risk premium large enough to
 compensate for that part of the total risk that diversification could
have eliminated?
A high return for high risk is a possibility; however, this is
not usually guaranteed.
c. Explain the difference between total risk, diversifiable risk, and
market risk.
Total risk includes all possible factors that may influence an
investment. Diversifiable risk can be eliminated through
adding more stocks to a portfolio. Market risk is the risk that
encompasses all securities in the market.
d. How might the desire for diversification of individual retirement
funds affect the structure of U.S. investments?
Usually, people accrue most value into one retirement fund. If
these funds were diversified, the market would see a shift
from stocks and bonds to 401Ks and IRAs.
7. Change Table 1 by substituting Year 1 through Year 5 for the states of
the economy.
a. Plot the characteristic lines for CPC, Morely, and T-bills showing the
returns on the index (the market) on the X-axis and the returns on
the asset on the Y-axis. Estimate (by visual inspection) the slope for
each line. If you are using the spreadsheet model, compute the slope
coefficients. How do these compare to the betas provided in Table 1?
b. What is the significance of the distance between the plot points and
the regression line, that is, the errors?
This shows the volatility of the expected returns.
c. What do betas measure, and how are they used in risk analysis?
Beta measures the growth or reduction of an investment in
comparison to the market index (Often the S & P 500).
d. Develop a chart depicting the beta and expected return for each
security, determined from the data provided by the investment
bankers. Does the risk and return relationship appear reasonable
relative to the market?
8. Using T-bonds as a risk-free rate and the NASDAQ index as the market,
 a. Plot the Security Market Line (SML).
b. Calculate the required rate of return for CPC, Morely, and EAT
based on the Security Market Line. Compare the required return
from the SML with the expected return from Question 1. Explain the
decision to either buy or sell each of the stocks, given this
information.
c. Are the stocks in equilibrium? If not, how would equilibrium be
restored?
9. Filmore Enterprises is expected to be similar to a company composed of
40% CPC and 60% EAT.
a. Compute the beta coefficient for a 40/60 portfolio of CPC-EAT and
then determine its required rate of return. How does the required
return compare with the expected return from Table 2? Explain why
you would or would not purchase this portfolio.
b. Suppose Kathy and Randy decided to provide a greater share of the
up-front capital so that the long-term debt ratio was below that
represented by the CPC-EAT portfolio. What impact would this have
on Filmore Enterprises’ risk and required return on equity?
This would reduce both Filmore Enterprises’ risk and their
required return on equity.
10. The SML might shift in response to various economic changes. A change
in the SML affects security prices and rates of return.
a. Suppose investors raised their expectations for inflation by 4
percentage points over current estimates as reflected in the 5.2%
T-bond rate. Explain the effect this would have on the SML and on
the returns required on high- versus low-risk securities.
This would increase required return across the board; which
would raise the SML across the y-axis.
b. Disregard Question 10a and assume that investors’ risk aversion
increased enough to cause the market risk premium to rise by 4
percentage points. Explain what effect this would have on the SML
and on returns of high-risk versus low-risk securities.
 This would have a similar effect to the increase in inflation,
required returns would increase as would the SML across the
y-axis.
c. Discuss the kinds of changes Questions 10a and 10b would have on
short-run and long-run effects; for example, might an increase in
expected inflation lead to lower returns in the short run followed by
higher returns in the long run?
Yes; inflationary adjustments to returns are usually short-
term.
11. Rather than focusing on risk from an investors’ decision-making per-
spective, consider the risk of corporate decisions and how investors’
perceptions affect the “true risk” of corporate decisions.
a. Why is it important for operating managers to be cognizant of the
way investors look at risk?
How investors perceive risk affects how much capital
managers have at hand at any particular moment in time.
This can affect many decisions that require capital.
b. Suppose a particular decision appears particularly risky to investors
(for instance, it would make the firm look risky), but the firm’s
managers, who know more about the situation than investors, think
the decision is really not very risky. How might this situation affect
the decision to accept a particular project based on each of the
following factors?
(1) The project can be financed with internal funds; therefore, the
firm does not need to sell securities to undertake the project.
Decision should be accepted.
(2) The project is very large, and securities must be sold to finance it.
Decision may be difficult to finance due to investors
viewpoint of risk.
(3) The project is long-term; therefore, it will take years for the
company to complete the project and begin receiving cash flows.
This may bog down the company for years; further
decreasing investor capital.
 (4) The project is short-term, so the company can complete it and
receive cash flows within a few months.
Project should be undertaken; investors will see there is
not much risk in a short period of time.
c. How would your answers to Question 11b change if the project
appeared safe to investors, but the company managers knew that it
was quite risky?
My answers would be perfectly reversed.