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Financial Management and Policy/Financial Management

Lecture#3 and 4 Risk and Return on investment

Q No. 1 Two stock prices for six days are given below.

Price A Price B
25 55
29 60
33 61
29 63
26 61
29 60

Calculate:

1. Average return of both stock


2. Standard deviation of each stock
3. Coefficient of Variation of each stock
4. Which stock is less risky based on Standard deviation?
5. Which stock you will select based on Coefficient of variation?

Q2. Consider the following scenario analysis:

Scenario Probability Stocks Bonds

Recession 0.30 -6 % +15%


Normal Economy 0.30 +14 +7
Boom 0.40 +26 +5

a) Calculate the expected rate of return and standard deviation for each investment?
b) Which investment would you prefer?

Q3. Use the data in the previous problem and consider a portfolio with weights of 0.70 in
stocks and 0.30 in bonds.

a) What is the rate of return on the portfolio in each scenario?


b) What is the expected rate of return and standard deviation of the portfolio?
c) Would you prefer to invest in the portfolio, in stocks only, or in bonds only?
Q4. (Student Practice)

Use the data in the previous problem and consider a portfolio with weights of 0.60 in stocks
and 0.40 in bonds.

a) What is the rate of return on the portfolio in each scenario?


b) What is the expected rate of return and standard deviation of the portfolio?
c) Would you prefer to invest in the portfolio, in stocks only, or in bonds only, give reason?

Q5.
a) A share of stock with a beta of .80 now sells for $45. Investors expect the stock to pay a
year-end dividend of $1.80. The T-bill rate is 4.5 percent, and the market risk premium is
7 percent. If the stock is perceived to be fairly priced today, what must be investors’
expectations of the price of the stock at the end of the year?

b) The following table shows betas for several companies. Calculate each stock’s expected
rate of return using CAPM. Assume the risk free rate of interest is 9 percent. Use a 6
Percent risk premium for the market portfolio.

Company Beta
Cisco 2.03
CitiGroup 1.63
Merck 0.50
Walt Disney 0.74

c) If the expected rate of return on the market portfolio is 14 percent and T- bills yield is 6
percent, what must be the beta of a stock that investors expect to return 10 percent?
d) You have equal investment in all four stocks given in part (b) of this question. What
would be your portfolio beta?
e) Student practice: Suppose you have investment as follows:

Cisco 20%
CitiGroup 20%
Merck 30%
Walt Disney 30%

Take the Beta as given above and calculate your portfolio beta.
Q No.6

Suppose kRF = 5%, kM = 10% and kA = 12%.


a. Calculate Stock A’s beta.
b. If Stock A’s beta were 2.0, what would be A’s new required rate of return?

Q No.7

Suppose kRF = 9%, kM = 14%, and bi = 1.3.


a. What is ki, the required rate of return on stock i?
b. Now suppose kRF (1) increases to 10 percent or (2) decreases to 8 percent. The slope of
the SML remains constant. How would this affect kM and ki?

Q No.8
Suppose you hold a diversified portfolio consisting of a $7500 investment in each of 20 different
common stocks. The portfolio beta is equal to 1.12. Now suppose you have decided to sell one of
the stocks in your portfolio with a beta equal to 1.0 for $7500 and to use these proceeds to buy
another stock for your portfolio. Assume the new stock’s beta is equal to 1.75. Calculate your
portfolio’s new beta.

Q No.9: Student Practice


Market rate of return is 18%, risk free rate of return 8% and beta is 1.2

Calculate required rate of return


Calculate risk premium

Q No.10: Student Practice


Market rate of return is 14%, beta is 1.5 and required rate of return is 18.5%. What is risk free
rate of return?

Q No.11: Student Practice


Here are stock market and Treasury bill returns between 1997 and 2001

Year Stock return T-Bill return


1997 31.29 5.26
1998 23.43 4.86
1999 23.56 4.68
2000 -10.89 5.89
2001 -10.97 3.83

a.What was the risk premium on common stock in each year?


b. What was the average risk premium?
c.What was the standard deviation of the risk premium?
Q No. 12: Student Practice

ECRI Corporation is a holding company with four main subsidiaries. The percentage of its
business coming from each subsidiaries, and their respective betas, are as follows:

Subsidiary % of Business Beta


Electric utility 60% 0.70
Cable company 25 0.90
Real estate 10 1.30
International/special projects 5 1.50

a. What is the holding company’s beta?


b. Assume that the risk-free rate is 6 percent and the market risk premium is 5 percent. What
is the holding company’s required rate of return?