Homework 5

A stock with a beta of 0.8 has an expected rate of return of 12%. If the market return this year turns out to be 5 percentage points below expectations, what is your best guess as to the rate of return on the stock?

8%. Beta tells us how sensitive the stock return is to changes in market performance. The market return was 5% less than your prior expectation. Therefore, the stock would be expected to fall short of your original expectation by: 0.8 × 5% = 4% The "updated" expectation for the stock return is 12% − 4% = 8%.

The risk-free rate is 6% and the expected rate of return on the market portfolio is 13%. A. Calculate the required rate of return on a security with a beta of 1.25. Note: Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places. B. If the security is expected to return 16%, is it overpriced or underpriced?

A. 14.75%. Required return = rf + β(rm − rf) = 6% + [1.25 × (13% − 6%)] = 14.75% B. The security is underpriced. Its expected return is greater than the required return given its risk.

When attempting to forecast for extremely long intervals, such as 50 years, it is best to use: A. Geometric Averages B. Arithmetic Averages C. Expected Return Averages D. Forecasting Averages E. Long Range Modeling Averages

C. Expected Return Averages

N Corp has a variable cost per unit of $1.20, and the lease payment on the production facility runs $4,200 per month. N Corp sells the units at $4.60 and has depreciation equal to $225. What is the amount of units that M Corp needs in order to break-even with cash? A. 955 B. 1,005 C. 1,155 D. 1,205 E. 1,235

E. 1,235 Cash Break-Even = (FC + 0)/(P - v) Cash BE = ($4,200 + $0)/($4.60 − $1.20) Cash BE = ($4,200 + $0)/($3.40) = 1,235 units Notice that the cash break even excludes depreciation since this is a non-cash expense.

Connor Corp. has large amount of data that they are trying to analyze from the last 15 years. They have an arithmetic sales growth average of 12% and a geometric average growth of 9%. Using Blume's formula, what would the forecast sales growth be for the next five years? A. 8.44% B. 9.05% C. 10.54% D. 10.95% E. 11.14%

E. 11.14% R(5) = (5 − 1)/14 × 9% + (15 − 5)/14 × 12% R(5) = (4)/14 × .09 + (10)/14 × .12 R(5) = .0257 + .0857 R(5) = .1114 = 11.14%

T or F: The arithmetic average tells you what you actually earned per year on average, whereas the geometric average tells you what you earned in a typical year.

False: The arithmetic average tells you what you earned in a typical year, whereas the geometric average tells you what you actually earned per year on average. The definitions are reversed in the question.

N Corp has a variable cost per unit of $1.20, and the lease payment on the production facility runs $4,200 per month. N Corp sells the units at $4.60 and has depreciation equal to $225. What is the amount of units that N Corp needs in order to break-even? A. 1,301 B. 1,500 C. 1,701 D. 2,000 E. 2,201

A. 1,301 Break Even Level = (FC + D) / (P − v) BE = ($4,200 + $225)/($4.60 − $1.20) BE = ($4,425)/($3.40) = 1,301 units

T or F: The Accounting Break-Even is the sales level that results in the same project net income as the prior year.

False: The Accounting Break-Even is the sales level that results in zero project net income.