P8- 1 Rate of return

A financial analyst for Smart Securities Limited, Paul Chan, wishes to estimate the rate of return for two
similar-risk investments, A and B. Paul’s research indicates that the immediate past returns will serve as
reasonable estimates of future returns. A year ago, investment A and investment B had market values of
$63,000 and $35,000, respectively. During the year, investment A generated cash flows of $6,100, and
investment B generated cash flows of $2,800. The current market values of investments A and B are
$71,000 and $32,000, respectively.

a. Calculate the expected rate of return on investments A and B using the most recent year’s data.

 Expected Rate of Return on Investment A:

Ct + Pt−Pt −1
r=
Pt −1
$ 6,1000+($ 71,000−$ 63,000)
=
$ 63,000
r= 22.38%
 Expected Rate of Return on Investment B:
Ct + Pt−Pt −1
r=
Pt −1
$ 2,800+($ 35,000−$ 32,000)
=
$ 32,000
r= 18.33%

b. Assuming that the two investments are equally risky, which one should Paul recommend? Why?

 Investment A should be selected since it has a higher rate of return for the same level of
risk

P8-2 Return calculations

For each of the investments shown in the following table, calculate the rate of return earned over the
unspecified time period.

Investment Cash Flow during Beginning of Period End of Period Value

Period Value
A $-2,800 $23,400 $20,100
B 16,000 225,000 324,000
C 700 6,500 8,000
D 3,580 36,600 46,500
E -500 62,700 52,800
 Ct + Pt−Pt −1
r=
Pt −1

Investment Calculation Kt(%)

A −$ 2,800+($ 20,100−$ 23,400) -26.07%
$ 23,400
B $ 16,000+($ 324,000−$ 225,000) 51.11%
$ 225,000
C $ 700+( $ 8,000−$ 6,500) 33.85%
$ 6,500
D $ 3,580+($ 46,500−$ 36,600) 36.83%
$ 36,600
E −$ 500+($ 52,800−$ 62,700) -16.59%
$ 62,700

P8-4 Risk analysis

Solar Designs is considering an investment in an expanded product line. Two possible types of expansion
are being considered. After investigating the possible outcomes, the company made the estimates
shown in the following table.

Expansion A Expansion B
Initial Investment $12,000 $12,000
Annual Rate of Return
Pessimistic 16% 10%
Most Likely 20% 20%
Optimistic 24% 30%

a. Determine the range of the rates of return for each of the two projects.

Expansion Range
A 24% - 16%= 8%
B 30% - 10%= 20%

b. Which project is less risky? Why?

 Expansion A is less risky since the range of outcomes for A is smaller than the range of
Expansion B.

c. If you were making the investment decision, which one would you choose? Why? What does this
decision imply about your feelings toward risk?
  Since the most likely return for both expansion is 20% and the initial investments are
equal, the answer depends on your risk preference.

d. Assume that expansion B’s most likely outcome is 21% per year and that all other facts remain the
same. Does your answer to part c now change? Why?

 The answer is no longer clear since it now involves a risk-return trade-off. Expansion B
has a slightly higher return but more risk while A has both lower return and lower risk.

P8- 5 Risk and probability

Micro-Pub, Inc., is considering the purchase of one of two microfilm cameras, R and S. Both should
provide benefits over a 10-year period, and each requires an initial investment of $4,000. Management
has constructed the accompanying table of estimates of rates of return and probabilities for pessimistic,
most likely, and optimistic results.

a. Determine the range for the rate of return for each of the two cameras.

Camera Range
R 30% - 20%= 10%
S 35% - 15%= 20%

b. Determine the expected value of return for each camera.

Camera Possible Probability Expected Return Weighted Value

Outcomes Pri Ki (%) Ki*Pri
R Pessimistic .25 20 5.00
Most Likely .50 25 12.50
Optimistic .25 30 7.50
1 Expected Return 25
Camera Possible Probability Expected Return Weighted Value
Outcomes Pri Ki (%) Ki*Pri
S Pessimistic .20 15 3.00
Most Likely .55 25 13.75
Optimistic .25 35 8.75
1 Expected Return 25.50

c. Purchase of which camera is riskier? Why?

 Camera S is considered more risky than Camera R because it has much broader range of
outcomes. The risk-return trade-off is present because Camera S more risky and also
provides a higher return than Camera R.

P8–7 Coefficient of variation

 Metal Manufacturing has isolated four alternatives for meeting its need for increased production
capacity. The following table summarizes data gathered relative to each of these alternatives.

a. Calculate the coefficient of variation for each alternative.

CV = (SD/x̄)

A= 7%/20% = .35

B= 9.5%/22%= .43

C= 6%/19%= .32

D= 5.5%/16%= .34

b. If the firm wishes to minimize risk, which alternative do you recommend? Why?

 Alternative C has the lowest coefficient of variation and is the least risky relative to the
other choices.

P8–8 Standard deviation versus coefficient of variation as measures of risk

Greengage, Inc., a successful nursery, is considering several expansion projects. All the alternatives
promise to produce an acceptable return. Data on four possible projects follow

a. Which project is least risky, judging on the basis of range?

Project A is least risky based on range with a value of 4%

b. Which project has the lowest standard deviation? Explain why standard deviation may not be an
entirely appropriate measure of risk for purposes of this comparison.

 Project A is least risky based on standard deviation with a value of 2.9%. Standard
deviation is not the appropriate measure of risk since the projects have different
returns.

c. Calculate the coefficient of variation for each project. Which project do you think Greengage’s owners
should choose? Explain why.

A= 2.9%/12% = .24

B= 3.2%/12.5%= .26

C= 3.5%/13%= .27

D= 3.0%/12.8%= .23

In this case, Project A is the best alternative since it provides the least amount of risk for
each percent of returned earned. Coefficient of variation is probably the best
measurement in this instance since it provides a standardized method of measuring the
risk-return trade-off for investments with different returns.

P8-10 Assessing return and risk

Swift Manufacturing must choose between two asset purchases. The annual rate of return and the
related probabilities given in the following table summarize the firm’s analysis to this point.

a. For each project, compute:

 1. Range: 1.00 - (-.10) = 1.10

n
k   k i Pr i
2. Expected return: i 1

Rate of Return Probability Weighted Value Expected Return

n
k   k i Pr i
ki Pri ki x Pri i 1

-.10 .01 -.001

.10 .04 .004
.20 .05 .010
.30 .10 .030
.40 .15 .060
.45 .30 .135
.50 .15 .075
.60 .10 .060
.70 .05 .035
.80 .04 .032
1.00 .450
n
  (k  k )
i
2
3. Standard Deviation: i 1 x Pri
ki k ki  k ( ki  k ) 2 Pri ( ki  k ) 2 x P
ri

-.10 .450 -.550 .3025 .01 .003025

.10 .450 -.350 .1225 .04 .004900
.20 .450 -.250 .0625 .05 .003125
.30 .450 -.150 .0225 .10 .002250
.40 .450 -.050 .0025 .15 .000375
.45 .450 .000 .0000 .30 .000000
.50 .450 .050 .0025 .15 .000375
.60 .450 .150 .0225 .10 .002250
.70 .450 .250 .0625 .05 .003125
.80 .450 .350 .1225 .04 .004900
1.00 .450 .550 .3025 .01 .003025.
.027350
σProject 257 = .027350 = .165378

.165378
CV   .3675
4. .450
Project 432

1. Range: .50 - .10 = .40

 n
k   k i Pr i
2. Expected return: i 1

Rate of Return Probability Weighted Value Expected Return

n
k   k i Pr i
ki Pri ki x Pri i 1

.10 .05 .0050

.15 .10 .0150
.20 .10 .0200
.25 .15 .0375
.30 .20 .0600
.35 .15 .0525
.40 .10 .0400
.45 .10 .0450
.50 .05
.0250
1.00 .300
n
  (k  k )
i
2
3. Standard Deviation: i 1 x Pri
ki k ki  k ( ki  k ) 2 Pri ( ki  k ) 2 x P
ri

.10 .300 -.20 .0400 .05 .002000

.15 .300 -.15 .0225 .10 .002250
.20 .300 -.10 .0100 .10 .001000
.25 .300 -.05 .0025 .15 .000375
.30 .300 .00 .0000 .20 .000000
.35 .300 .05 .0025 .15 .000375
.40 .300 .10 .0100 .10 .001000
.45 .300 .15 .0225 .10 .002250
.50 .300 .20 .0400 .05 .002000
.011250

σProject 432 = .011250 = .106066

.106066
CV   .3536
4. .300

b. Bar Charts
Project 257
Probability

0.3

0.25

0.2

0.15

0.1

0.05

0
-10% 10% 20% 30% 40% 45% 50% 60% 70% 80% 100%

Rate of Return

Project 432

0.3

0.25

0.2

0.15

0.1

0.05

0
10% 15% 20% 25% 30% 35% 40% 45% 50%

Probability
Rate of Return
c. Summary Statistics

Project 257 Project 432

Range 1.100 .400
k
Expected Return ( ) 0.450 .300
Standard Deviation ( k ) 0.165 .106
Coefficient of Variation (CV)0.3675 .3536

Since Projects 257 and 432 have differing expected values, the coefficient of
variation should be the criterion by which the risk of the asset is judged. Since
Project 432 has a smaller CV, it is the opportunity with lower risk.