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Prob Set#4-Risk - Return - Problems

This document contains practice problems related to risk and return in financial management. It includes 8 questions addressing topics such as calculating beta, using the capital asset pricing model to determine required rates of return, constructing portfolios with targeted risk levels, and analyzing investments based on their expected returns and risk. The problems provide financial data on companies and securities to help students practice applying concepts related to risk, return, diversification, and the security market line.

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Kenya Levy
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132 views4 pages

Prob Set#4-Risk - Return - Problems

This document contains practice problems related to risk and return in financial management. It includes 8 questions addressing topics such as calculating beta, using the capital asset pricing model to determine required rates of return, constructing portfolios with targeted risk levels, and analyzing investments based on their expected returns and risk. The problems provide financial data on companies and securities to help students practice applying concepts related to risk, return, diversification, and the security market line.

Uploaded by

Kenya Levy
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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UNIVERSITY OF THE WEST INDIES

MONA SCHOOL OF BUSINESS & MANAGEMENT


FINANCIAL MANAGEMENT I – MS28D

Practice Problems – Risk & Return

Question 1
You are analyzing the beta for Hewlett Packard and have broken down the company into four
broad business groups, with market values and betas for each group as follows:

Business Group Market Value of Equity Beta


Mainframes $ 2.0 billion 1.10
Personal Computers $ 2.0 billion 1.50
Software $ 1.0 billion 2.00
Printers $ 3.0 billion 1.00

(i) Estimate the beta for Hewlett Packard as a company. Is this beta going to be equal to the
beta estimated by regressing past returns on HP stock against a market index. Why or
Why not?
(ii) If the treasury bond rate is 7.5%, estimate the cost of equity for Hewlett Packard (the
market risk premium is estimated to be 5.5%). Estimate the cost of equity for each
division. Which cost of equity would you use to value the printer division?

Question 2

(a) The Suzuki Motor Company is contemplating issuing stock to finance investment in
producing a new sports-utility vehicle, the Seppuku. Financial analysts within Suzuki
forecast that this investment will have precisely the same risk as the market portfolio,
where the annual return to the market portfolio is expected to be 15% and the current
risk-free interest rate is 5%. The analysts further believe that the expected return to the
Seppuku project will be 20% annually. Derive the maximal beta value that would induce
Suzuki to issue the stock.

(b) Risk-free securities are currently expected to yield 7.5 percent, and the market risk
premium is 4 percent.

(i) What’s the return on the market portfolio?


(ii) If a security has a beta of 1.5, what is its required rate of return?
(iii) If the expected return on the security in (ii) were 10 percent, what would we
expect to happen to the security’s price?
Financial Management I – MGMT2023(MS28D) Risk & Return - Problems Page 2

(c) The risk-free rate is 6 percent, the expected return on the market is 16 percent, and the
standard deviation of annual returns on the market is 20 percent. In addition, you are
advised that Security D has a beta of 0.6 and a standard deviation of 16%.

You wish to construct a portfolio with a beta of 0.60. One way to do this is to invest 60
percent of your wealth in the market portfolio and the balance in risk-free securities.
Another way is to invest in security D. Your broker, a recent graduate from a nationally
ranked MBA program, tells you that if capital market theory (CAPM) is correct, both of
these portfolios should earn the same expected return; therefore you should be indifferent
between holding one or the other. Is your broker correct?

(d) What is a beta coefficient, and how are betas used in risk analysis?

Question 3

In the capital asset pricing model, all investors are assumed to hold the market portfolio? What
investments are in the market portfolio? In practice, why might investors choose not to hold the
market portfolio?

Question 4

After recently graduating, you just landed a job with Investment Advisors, Inc., a large financial
services corporation. The economic forecasting staff of the firm has developed a sophisticated
computer program used to estimate the rates of return on various investment alternatives. The
program has produced expected rates of return and the beta coefficients of the following
investments:

SECURITY RETURN ( k̂ ) RISK (BETA)


High Tech 17.4% 1.29
Stock Market Index 15.0% 1.00
Reggae Rubber 13.8% 0.68
Government T-Bills 8.0% 0.00
Collectors 1.7% (0.86)

Required:

(a) Write out the security market line equation, use it to calculate the required rate of return
of each investment, and then graph the relationship between each alternative’s expected
and required return (clearly identify the security market line on your graph).
(b) Which of the alternatives would you recommend for investment?

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Financial Management I – MGMT2023(MS28D) Risk & Return - Problems Page 3

Question 5

Which of the following statements is/are correct?

A. Mean and standard deviation have the same units.


B. Mean is a measure of dispersion.
C. If two random variables have a negative covariance it means they tend to move in the
opposite direction.
D. If two random variables don't move together or in opposite directions on average at all
they have a zero covariance.
E. Correlation coefficients must be equal to -1 or +1 or lie in between.

Question #6:

Dana has a portfolio of 8 securities, each with a market value of $5,000. The current beta of the
portfolio is 1.28 and the beta of the riskiest security is 1.75. Dana wishes to reduce her portfolio
beta to 1.15 by selling the riskiest security and replacing it with another security with a lower
beta. What must be the beta of the replacement security?

Question #7:

Assume you want to construct a portfolio with a 14 percent return from the following two
securities:

Security Expected Return Beta


1 16% 1.12
2 12.5% 0.94

What percentage of your portfolio should be invested in Security 1?

Question #8:

The Kish Investment Fund, in which you plan to invest some money, has total capital of $500
million invested in five stocks (see Table 1). The current risk-free rate is 6 percent, whereas
market returns have the estimated probability distribution for the next period as shown in the
following (Table 2).

Table 1 Table 2
STOCK’S BETA MARKET
STOCK INVESTMENT PROB.
COEFFICIENT RETURN
A $160 million 0.5 0.1 7%
B 120 million 2.0 0.2 9%
C 80 million 4.0 0.4 11%
D 80 million 1.0 0.2 13%
E 60 million 3.0 0.1 15%

Page 3
Financial Management I – MGMT2023(MS28D) Risk & Return - Problems Page 4

Required:

a. Compute the fund's required rate of return for the next period.
b. Suppose the president receives a proposal for a new stock. The investment needed to take a
position in the stock is $50 million, it will have an expected return of 15%, and its estimated
beta is 2.0. Should the new stock be purchased? At what rate of return should the fund be
indifferent to purchasing the stock?

Page 4

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