James D. Lowe
Trident University International
FIN301 - Principles of Finance
Module 3
Case Assignment
Assignment:
1. For each of the scenarios below, explain whether or not it represents a diversifiable or an undiversifiable risk. Please consider the issues from the viewpoint of investors. Explain your reasoning
a. There's a substantial unexpected increase in inflation.
b. There's a major recession in the U.S.
c. A major lawsuit is filed against one large publicly traded corporation.
2. Use the CAPM to answer the following questions:
a. Find the Expected Rate of Return on the Market Portfolio given that the Expected Rate of Return on Asset "i" is 12%, the Risk-Free Rate is 4%, and the Beta (b) for Asset "i" is 1.2.
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Diversifiable risk
The entire economy will not be affected; in fact some companies in areas not affected by the lawsuit will benefit as they will be able to fill a void in the market as the company in question faces legal precedings.
2. Use the CAPM to answer the following questions:
a. Find the Expected Rate of Return on the Market Portfolio given that the Expected Rate of Return on Asset "i" is 12%, the Risk-Free Rate is 4%, and the Beta (b) for Asset "i" is 1.2.
CAPM (Capital Asset Pricing Model equation is: r A= r f + beta A (r m - r f) risk free rate= r f = 4% beta of stock= beta A= 1.2 return on market portfolio= r m = to be determined required return on stock r A = 12.00%
Therefore, r m = 10.666% =(12.%-4.%)/1.2+4.%
Answer: return on market portfolio= 10.666%
b. Find the Risk-Free Rate given that the Expected Rate of Return on Asset "j" is 9%, the Expected Return on the Market Portfolio is 10%, and the Beta (b) for Asset "j" is 0.8.
CAPM (Capital Asset Pricing Model equation is: r A= r f + beta A (r m - r f) risk free rate= r f = beta of stock= beta A= 0.8 return on market portfolio= r m = 10% required return on stock r A = 9%
Therefore, r f = 5 % =(0.8*10.-9.)/(0.8-1)
Answer: risk free rate= 5 %
c. What do you think the Beta (ß) of your portfolio would be if you owned half of all the stocks traded on the major exchanges? Explain.
The beta would be close to 1
This is
You recently purchased a stock that is expected to earn 12% in a booming economy, 8% in a normal economy and lose 5% in a recessionary economy. There is a 15% probability of a boom, a 75% chance of a normal economy, and a 10% chance of a recession. What is your expected rate of return on this stock?
4) Using the stock price and return data in Exhibits 5 and 6, estimate the CAPM beta
a. Calculate the expected return over the 4-year period for each of the three alternatives.
11. What is the Cost of Equity? ke = Risk Free Rate + (Beta X Risk Premium of 7.5% points). .03 + (.99 x .075) = 10.43%.
1. You have a portfolio with a beta of 3.1. What will be the new portfolio beta if you keep 85 percent of your money in the old portfolio and 15 percent in a stock with a beta of 4.5?
12. Using the data from the previous question, what trade is necessary to increase the beta of the portfolio to 1.8 from the original beta of 1.5
b. What would Mrs. Beach have to deposit if she were to use common stock and earned an average rate of return of 11%.
Given these approximations, the CAPM model would total the risk-free rate and the market risk premium times beta to arrive at a cost of equity of 9.68%, which reflects the investors’ expected return from investing in shares of the company.
a. What risk-free rate and risk premium did you use to calculate the cost of equity?
Risk free rate + Equity Beta * (Expected return on market - Risk free rate)
Utilizing the fundamental concepts of the Capital Asset Pricing Model (CAPM), the expected return for Wal-Mart stock is 7.01% [E(R)]. This is a result of a risk-free rate (Rf) of 3.68%, which was the provided 10-year government bond yield to use as a proxy for the risk-free rate. The beta (β ) of Wal-Mart was 0.66 according to the provided Bloomberg beta estimate. Additional data was provided on the U.S. market risk premium [E(RM) – Rf] of 5.05%. In following the general concepts of CAPM, there are some general assumptions: no transaction costs, all assets are publicly traded,
Solutions to Valuation Questions 1. Assume you expect a company’s net income to remain stable at $1,100 for all future years, and you expect all earnings to be distributed to stockholders at the end of each year, so that common equity also remains stable for all future years (assumes clean surplus). Also, assume the company’s β = 1.5, the market risk premium is 4% and the 20-30 year yield on risk free treasury bonds is 5%. Finally, assume the company has 1,000 shares of common stock outstanding. a. Use the CAPM to estimate the company’s equity cost of capital. • re = RF + β * (RM – RF) = 0.05 + 1.5 * 0.04 = 11% b. Compute the expected net distributions to stockholders for each future year. • D = NI – ΔCE = $1,100 – 0 = $1,100 c. Use the
d. What would be the investor 's certainty equivalent return for the optimally chosen combination? 2. Consider an investor who has an asset allocation of 50% in equities and the rest in T-Bills. Suppose the expected rate of return on equities is 10%/year and the standard deviation of the return on equities is 15%/year. T-Bills earn 6%/year. a. What is the implied risk aversion coefficient of the investor?
Using the same market risk premium and risk free rate (5.5% & 4.62% respectively) given in the case, the averaged beta of 1.40, the pretax cost of debt of 7.65%, and the weighted average of debt & equity, the products & systems
The remaining alternatives for this client are to invest in U.S. Rubber, a market portfolio, and a 2-stock portfolio of High Tech and Collections. The expected rates of return are 9.8% in U.S. Rubber, 10.5% in a market portfolio, and 6.7% in the 2-stock portfolio.