Chapter 8, Problem 23IC

Fundamentals of Financial Manageme...

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

Chapter
Section

Fundamentals of Financial Manageme...

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

RISK AND RETURN Assume that you recently graduated with a major in finance. You just landed a job as a financial planner with Merrill Finch Inc., a large financial services corporation. Your first assignment is to invest $100,000 for a client. Because the funds are to be invested in a business at the end of 1 year, you have been instructed to plan for a 1-year holding period. Further, your boss has restricted you to the investment alternatives in the following table, shown with their probabilities and associated outcomes. (For now, disregard the items at the bottom of the data; you will fill in the blanks later.) State of the Economy Probability Returns on Alternative Investments Estimated Rate of Return T-Bills High Tech Collections U.S. Rubber Market Portfolio 2-Stock Portfolio Recession 0.1 5.5% (27.0%) 27.0% 6.0% (17.0%) 0.0% Below average 0.2 5.5 (7.0) 13.0 (14.0) (3.0) Average 0.4 5.5 15.0 0.0 3.0 10.0 7.5 Above average 0.2 5.5 30.0 (11.0) 41.0 25.0 Boom 0.1 5.5 30.0 (21.0) 26.0 38.0 12.0 r 1.0% 9.8% 10.5% σ 0.0 13.2 18.8 15.2 3.4 CV 13.2 1.9 1.4 0.5 b −0.87 0.88 Note:aThe estimated returns of US. Rubber do not always move in the same direction as the overall economy. For example, when the economy is below average, consumers purchase fewer tires than they would if the economy was stronger. However, if the economy is in a flat-out recession, a large number of consumers who were planning to purchase a new car may choose to wan and Instead purchase new tires for the car they currently own. Under these circumstances, we would expect U.S. Rubber’s stock price to be higher if there is a recession than if the economy was just below average.Merrill Finch’s economic forecasting staff has developed probability estimates for the state of the economy; and its security analysts developed a sophisticated computer program to estimate the rate of return on each alternative under each state of the economy. High Tech Inc. is an electronics firm. Collections Inc. collects past-due debts, and U.S. Rubber manufactures tires and various other rubber and plastics products. Merrill Finch also maintains a “market portfolio” that owns a market-weighted fraction of all publicly traded stocks; you can invest in that portfolio and thus obtain average stock market results. Given the situation described, answer the following questions: a. 1. Why is the T-bill’s return independent of the state of the economy? Do T-bills promise a completely risk-free return? Explain. 2. Why are High Tech’s returns expected to move with the economy, whereas Collections’ are expected to move counter to the economy? b. Calculate the expected rate of return on each alternative and fill in the blanks on the row for r ^ in the previous table. c. You should recognize that basing a decision solely on expected returns is appropriate only for risk-neutral individuals. Because your client, like most people, is risk-averse, the riskiness of each alternative is an important aspect of the decision. One possible measure of risk is the standard deviation of returns. 1. Calculate this value for each alternative and fill in the blank on the row for σ in the table. 2. What type of risk is measured by the standard deviation? 3. Draw a graph that shows roughly the shape of the probability distributions for High Tech, U.S. Rubber, and T-bills. d. Suppose you suddenly remembered that the coefficient of variation (CV) is generally regarded as being a better measure of stand-alone risk than the standard deviation when the alternatives being considered have widely differing expected returns. Calculate the missing CVs and fill in the blanks on the row for CV in the table. Does the CV produce the same risk rankings as the standard deviation? Explain. e. Suppose you created a two-stock portfolio by investing$50,000 in High Tech and \$50,000 in Collections. 1. Calculate the expected retum( r ^ p ), the standard deviation(σp), and the coefficient of variation (CVp) for this portfolio and fill in the appropriate blanks in the table. 2. How does the riskiness of this two-stock portfolio compare with the riskiness of the individual stocks if they were held in isolation? f. Suppose an investor starts with a portfolio consisting of one randomly selected stock. 1. What would happen to the riskiness and to the expected return of the portfolio as more randomly selected stocks were added to the portfolio? 2. What is the implication for investors? Draw a graph of the two portfolios to illustrate your answer. g. 1. Should the effects of a portfolio impact the way investors think about the riskiness of individual stocks? 2. If you decided to hold a one-stock portfolio (and consequently were exposed to more risk than diversified investors), could you expect to be compensated for all of your risk; that is, could you earn a risk premium on the part of your risk that you could have eliminated by diversifying? h. The expected rates of return and the beta coefficients of the alternatives supplied by Merrill Finch’s computer program arc as follows: 1. Security 2. Return, r ^ 3. Risk (Beta) 4. High Tech 5. 12.4% 6. 1.32 7. Market 8. 10.5 9. 1.00 10. U.S. Rubber 11. 9.8 12. 0.88 13. T.bills 14. 5.5 15. 0.00 16. Collections 17. 1.0 18. (0.87) 1. What is a beta coefficient, and how arc betas used in risk analysis? 2. Do the expected returns appear to be related to each alternative’s market risk? 3. Is it possible to choose among the alternatives on the basis of the information developed thus far? Use the data given at the start of the problem to construct a graph that shows how the T-bill’s, High Tech’s, and the market’s beta coefficients are calculated. Then discuss what betas measure and how they are used in risk analysis. i. The yield curve is currently flat; that is, long-term Treasury bonds also have a 5.5% yield. Consequently, Merrill Finch assumes that the risk-free rate is 5.5%. 1. Write out the Security Market Line (SML) equation, use it to calculate the required rate of return on each alternative, and graph the relationship between the expected and required rates of return. 2. How do the expected rates of return compare with the required rates of return? 3. Does the fact that Collections has an expected return that is less than the T-bill rate make any sense? Explain. 4. What would be the market risk and the required return of a 50-50 portfolio of High Tech and Collections? Of High Tech and U.S. Rubber? j. 1. Suppose investors raised their inflation expectations by 3 percentage points over current estimates as reflected in the 5.5% risk-free rate. What effect would higher inflation have on the SML and on the returns required on high- and low-risk securities? 2. Suppose instead that investors’ risk aversion increased enough to cause the market risk premium to increase by 3 percentage points. (Inflation remains constant.) What effect would this have on the SML and on returns of high- and low-risk securities?

a.

1.

Summary Introduction

To explain: The reason for Treasury bill’s return is independent of the state of the economy and whether treasury bills give a completely risk-free return.

Risk and Return:

The risk and return are two closely related terms. The risk is the uncertainty attached to an event. In case of any investment, there is some amount of risk attached to it as there can be either gain or loss. While return in the financial term is that percentage which represents the profit in an investment. Higher risk is related to higher return and lower risk has a probability of lower return. The investor has to face a tradeoff between risk and return in terms of an investment.

Treasury bills:

The treasury bills are those short-term bonds or securities which have maturity period of less than one year. These are issued by the government for a shorter period and when the government needs to raise funds immediately.

Explanation
• The treasury bills are the return which is composed of real risk-free rate, in which 5.5% is risk-free rate.
• There is uncertainty about inflation, so it is not possible that the expected realized rate of return would be 5.5%.
• If the average of the inflation is 6% over the year, then the realized rate of return will be 4...

2.

Summary Introduction

To explain: The reason for H’s returns expected to move with the economy and C’s returns expected to move counter to the economy.

b.

Summary Introduction

To determine: The expected rate of return for each alternative.

The Expected Return on the Stock:

The expected return on stock refers to the weighted average of expected returns on those assets which are held in the portfolio.

c.

1.

Summary Introduction

To determine: The standard deviation of returns.

Standard Deviation:

The standard deviation refers to the stand-alone risk associated with the securities. It measures how much a data is dispersed with its standard value. The Greek letter sigma represents the standard deviation.

2.

Summary Introduction

To explain: The type of risk measured by the standard deviation.

3.

Summary Introduction

To prepare: A graph showing the probability distribution for H, U, and T.

d.

Summary Introduction

To determine: The missing values of coefficient of variation and comparison of risk rankings of the coefficient of variation with the standard deviation.

The Coefficient of Variation:

The coefficient of variation is a tool to determine the risk. It determines the risk per unit of return. It is used for measurement when the expected returns are same for two data.

e.

1.

Summary Introduction

The Expected Return on the Stock:

The expected return on stock refers to the weighted average of expected returns on those assets which are held in the portfolio.

Standard Deviation:

The standard deviation refers to the stand-alone risk associated with the securities. It measures how much a data is dispersed with its standard value. The Greek letter sigma represents the standard deviation.

The Coefficient of Variation:

The coefficient of variation is a tool to determine the risk. It determines the risk per unit of return. It is used for measurement when the expected returns are same for two data.

2.

Summary Introduction

To explain: The comparison of the riskiness of the 2-stock portfolios with the riskiness of the individual stock.

f.

1.

Summary Introduction

To explain: The effect on riskiness and to the expected return of the portfolio.

2.

Summary Introduction

To explain: The implication for investors and the graph of the two portfolios.

g.

1.

Summary Introduction

To explain: The impact of the portfolio on the thinking of the investors.

2.

Summary Introduction

To explain: The possibilities of earning a risk premium and the compensation of the risk.

h.

1.

Summary Introduction

To determine: The beta coefficient and the use of beta for the risk analysis.

2.

Summary Introduction

To explain: The relation of the expected return to each alternative market risk.

3.

Summary Introduction

To explain: The graph showing the calculation of the beta coefficient and the measure of the betas and use of them in the risk analysis.

i.

1.

Summary Introduction

To determine: The security-market line equation, the calculation of the required rate of return on each alternative and the graph showing the relationship between the expected and required rates of return.

2.

Summary Introduction

To determine: The comparison between the expected rates of return and the required rate of return.

3.

Summary Introduction

To explain: The sense of the fact that C has an expected returns less than T-bills.

4.

Summary Introduction

To determine: The market risk and the required return of a 50-50 portfolio of H and C and of H and U.

j.

1.

Summary Introduction

To determine: The effect of the higher inflation on the security market line and on the returns required on high and low-risk securities.

2.

Summary Introduction

To determine: The effect of the higher market risk premium on the security market line and on the returns required on high and low-risk securities.

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