BUS 365: Investments

Practice Problems
Risk and Return
1) For this question, please assume that markets are efficient. BRIEFLY answer the following.
Suppose that a risk-averse investor wants to form a well-diversified portfolio of ten stocks.
How might the investor go about choosing those stocks? What factors are important in that
choice?
2) Draw and label the Capital Market Line under the assumption that investors cannot short the
risk-free asset.
3) Consider three major drug companies. Eli Lilly has a beta of 0.31; Johnson & Johnson has a
beta of 0.24; Merck has a beta of 0.35. Currently, you have invested $5,000 in Merck and you do
not want to change that position. You have an additional $20,000 to invest and wish to form a
market-neutral portfolio of the three stocks.
a) How should you allocate the $20,000 between Eli Lilly stock and Johnson & Johnson stock?
b) Suppose that the risk-free rate is 4% and that the expected market return is 9%. What is the
expected return on your portfolio?
4) The following graph depicts the expected returns and standard deviations of 5 different assets.
You are a risk-averse investor who plans to invest in one (and only one) of those assets. You
have no other information on the assets and no way to get additional information on them.
Which assets would you definitely NOT choose? BRIEFLY explain your intuition. What
investor-specific factor would help you determine which of the remaining assets you would
choose? BRIEFLY explain.
Expected
Return

A
B

E
D

Risk
(Standard Deviation)

5) You have $100,000 to invest and wish to invest $50,000 in each of two stocks. Assuming that
you want to diversify as much as possible and that you have no other investments, how would
you go about choosing the two companies? What company characteristics are important in the

choice? Give an example of two companies that you might choose.

6) BRIEFLY discuss the implication(s) of using historical return data to estimate beta for a stock.
7) Assume that the CAPM is correct and applicable to markets. Assume also that markets are
equilibrium. Explain the collapse of Enrons stock in light of the two primary sources of stock
value--expected cash flows and risk.
8) Consider three major drug companies. Eli Lilly has a beta of 0.31; Johnson & Johnson has a
beta of 0.24; Merck has a beta of 0.35. Currently, you have invested $5,000 in Johnson &
Johnson and you do not want to change that position. You have an additional $25,000 to invest
and wish to form a market-neutral portfolio of the three stocks.
a) How should you allocate the $25,000?
b) Suppose that the risk-free rate is 3.5% and that the expected market return is 7.5%. What is
the expected return on your portfolio?
9) Consider the graph below. What (approximately) is the beta of the stock? BRIEFLY explain
your logic.

10) BRIEFLY evaluate the validity of the following argument. The CAPM is largely useless
because it relies on beta, which in turn relies on volatility. For example, a stock may go way up
during a period in which the market goes up by a smaller amount. Our estimate of beta would be

higher as a result. Therefore, this highly successful stock would be deemed to be more risky even
though it has done really well!
11) a) In simple terms, explain what a discount rate is. In doing so, be sure to mention the
specific factors that should (in theory) affect the discount rate.
b) How might we go about estimating one for use in valuing a stock?
c) How might we go about estimating one for use in valuing a company?
12) BRIEFLY explain how the Weighted Average Cost of Capital is used in financial analysis
and BRIEFLY outline how to estimate the various components of it.
13) In recent years, Stock A has suffered from a series of firm-specific events that have gradually
driven the stock price down while the market was moving up. You wish to estimate the beta of
Stock A for use in discounting future cash flows. Below is a table showing recent historical betas
for Stock A and its closest peers.
Stock Historical Beta
A
0.35
B
0.95
C
1.04
D
1.13
E
0.98
What beta would you use for Stock A? BRIEFLY explain your choice.
14) You wish to estimate the Weighted Average Cost of Capital for a company. Using the
information found below, what is your best estimate of the companys WACC?
Book value of debt
$2,000,000
Book value of equity
$1,000,000
Book value of preferred stock
$500,000
Current market value of preferred stock (per share)
$11.50
Expected market risk premium
4.2%
Historical correlation between equity returns and market returns
0.64
Market value of debt
$1,900,000
Market value of equity
$6,300,000
Market value of preferred stock
$485,000
Promised annual dividend on preferred stock
$1.15
Standard deviation of historical equity returns
53%
Standard deviation of historical market returns
21%
Yield-to-maturity on 5-year Treasury bonds
4.8%
Yield-to-maturity on companys existing debt
8.2%
Tax Rate
35%
15) You wish to estimate an appropriate discount rate for use in valuing Stock B. Consider the
following chart, which depicts one year of weekly, historical stock prices (normalized to $100
initial values) of the S&P 500 index, Stock A, and Stock B. Stock A and B are both very similar
companies in the same industry. Stock A has had no major firm-specific developments over the

period shown in the chart. In contrast, Stock B's company has had a series of firm-specific
problems during the year. What is your best estimate of the beta of Stock B? BRIEFLY explain
your intuition.

Historical Prices
$200

Price

$150

S&P 500 Index

Stock A
Stock B

$100
$50
$0
0

10

20

30

40

50

Week

16) You wish to form a portfolio of three companies such that the portfolio has a beta of 1.0.
Stock A has a beta of 1.5. Stock B has a beta of 0.8. Stock C has a beta of 0.6. You currently have
$50,000 invested in Stock A and you do not want to change that position. You have another
$100,000 to invest.
a) What positions should you take in Stock B and Stock C?
b) Suppose that the risk-free rate is 4.5% and that the expected market return is 8.5%. What is
the expected return on each of the three positions? What is the expected return on your portfolio?