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Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977
Textbook Problem

SECURITY MARKET LINE You plan to invest in the Kish Hedge Fund, which has total capital of $500 million invested in five stocks:

Stock Investment Stock’s Beta Coefficient
A $160 million 0.5
B 120 million 1.2
C 80 million 1.8
D 80 million 1.0
E 60 million 1.6

Kish’s beta coefficient can be found as a weighted average of its stocks betas. The risk-free rate is 6%, and you believe the following probability distribution for future market returns is realistic:

Probability Market Return
0.l -28%
0.2 0
0.4 12
0.2 30
0.1 50
  1. a. What is the equation for the security market line (SML)? (Hint First, determine the expected market return.)
  2. b. Calculate Kish’s required rate of return.
  3. c. Suppose Rick Kish, the president, receives a proposal from a company seeking new capital. The amount needed to lake a position in the stock is $50 million, it has an expected return of 15%, and its estimated beta is 1.5. Should Kish invest in the new company? At what expected rate of return should Kish be indifferent to purchasing the stock?

a.

Summary Introduction

To determine: The equation of the security market line.

Security Market Line:

The security market line is a line which shows the relationship between the risk which is measured by beta and the required return rate, which is for the individual securities.

Explanation

Given,

The risk-free rate is 6%.

Calculation of the expected market return:

The formula to calculate the expected market return is,

rM=(Probability×MarketReturn)

Substitute 0.1, 0.2, 0.4, 0.2 and 0.1 for the probabilities and (28%), 0%, 12%, 30% and 50% for the market return in the above formula.

rM=[0.1×(28%)+0.2×0%+0.4×12%+0.2×30%+0.1×50%]=[2.8%+0+4.8%+6%+5%]=13%

The market return rate is 13%

b.

Summary Introduction

To determine: The required rate of return.

The Required Rate of Return:

The required rate of return is the rate which should be minimum earned on an investment to keep that investment running in the market. When the required return is earned only then the users and the companies will invest in that particular investment.

c.

Summary Introduction

To determine: The decision of the new investment in the new company and the expected rate of return.

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