Finance ch 12 problems
Where will the following project's plot in relation to the security market line if the risk-free rate is 6% and the market risk premium is 9%? Which projects should be undertaken? A: IRR - 25%, Beta - 2.0 B: IRR - 22%, Beta - 1.6 C: IRR - 15%, Beta - 1.1 D: IRR - 11%, Beta - 0.8
Expected Return A= 6% + 2.0% (9%) = 24% vs. IRR of 25% A plots above SML and should be accepted. Expected Return B= 6% + 1.6% (9%) = 6% + 14.4% =20.4% vs. IRR of 22% B plots above SML and should be accepted. Expected Return C= 6% + 1.1% (9%) = 6% + 9.9% = 15.9% vs. IRR of 15% C plots below SML and should be rejected. Expected Return D= 6% + .8% (9%) = 6% + 7.2% = 13.2% vs. IRR of 11% D plots below SML and should be rejected.
Stock A has a current price of $25.00, a beta of 1.25, and a dividend yield of 6%. If the Treasury bill yield is 5% and the market portfolio is expected to return 14%, what should Stock A sell for at the end of an investor's two year investment horizon?
Expected Return = 5% + 1.25 (14% - 5%) = 5% + 11.25% = 16.25% Since total return is composed of dividend yield plus capital gains, the stock is expected to offer capital gains of 10.25% annually. The price in two years should be: 25.00(1.1025)2= 25.00 x 1.21551 = $30.39
why is beta thought to be a more relevant measure of risk than standard deviation for a diversified investor?
I agree to the statement that the stock's risk is measured by Beta in more efficient way than the standard deviation in well diversified portfolio. It is because in a well diversified portfolio, the standard deviation is minimized (close to zero) which does not give the proper indication of the risk. A beta will give the indication whether the fluctuation in stock is highly or not correlated with the market movement of the prices.
Calculate the expected rate of return for the following portfolio, based on a Treasury bill yield of 4% and an expected market return of 13%: A: weight - 20%, Beta - 1.6 B: weight - 25%, Beta - 1.2 C: weight - 10%, Beta - 1.0 D: weight - 30%, Beta - 0.9 E: weight - 15%, Beta - 0.8
Portfolio Beta = (.2 1.6) + (.25 1.2) + (.1 1.0) + (.3 .9) + (.15 .8) = .32 + .30 + .10 + .27 + .12 = 1.11 Expected Portfolio Return = rf+ Bp(rm- rf) = 4% + 1.11 (13% - 4%) = 4% + 9.99 = 13.99%
The manager of StarPerformer Mutual Fund expects the fund to earn a rate of return of 12 percent this year. The beta of the fund's portfolio is .8. If the rate of return available on risk-free assets is 5 percent and you expect the rate of return on the market portfolio to be 15 percent, should you invest in StarPerformer? Can you create a portfolio with the same risk as StarPerformer Mutual Fund, but with a higher expected rate of return? Explain why in reality, a mutual fund must be able to provide an expected rate of return that is higher than that predicted by the security market line in order for investors to consider the fund an attractive investment opportunity.
The CAPM implies that the expected rate of return that investors will demand of the portfolio is: r = rf + (rm - rf) = 5% + 0.8 x (15% - 5%) = 13% If the portfolio is expected to provide only a 12% rate of return, it is an unattractive investment. The portfolio does not provide an expected return that is sufficiently high relative to its risk. A portfolio that is invested 80% in a stock index mutual fund (with a beta of 1.0) and 20% in Treasury bills or a money market mutual fund (with a beta of zero) would have the same beta as StarPerformer Mutual Fund: = (0.80 x 1.0) + (0.20 x 0) = 0.80 However, the portfolio will provide an expected return of: (0.80 x 15%) + (0.20 x 5%) = 13% This is better than the expected return for StarPerformer Mutual Fund. The security market line provides a benchmark expected return that an investor can earn by mixing index funds with money market funds. Before an investor places funds with a professional mutual fund manager, the investor must be convinced that the mutual fund can earn an expected return (net of fees) in excess of the expected return available on an equally risky index fund strategy.
The stock of Newmont Mining, the world's largest gold producer, has above-average volatility but relatively low beta. Why?
Total risk is not the same as market risk. Some of the most variable stocks have below-average betas, and vice versa. Consider, for example, Newmont Mining. Newmont is the world's largest gold producer. The company cites the many risks that the company faces as "gold and other metals' price volatility, increased costs and variances in ore grade or recovery rates from those assumed in mining plans, as well as political and operational risks in the countries in which we operate and governmental regulation and judicial outcomes." These risks are considerable and are reflected in the high standard deviation of the returns on Newmont's stock. But they are not macro risks. When the U.S. economy is booming, gold prices are just as likely to slump, and a mine in some distant part of the world may well be hit by political unrest. So, while Newmont stock has above-average volatility, it has a relatively low beta.
