Chapter 08

Part4
RiskandtheRequiredRateofReturn
ChaptersinthisPart
Chapter8
RiskandReturn
Chapter9
TheCostofCapital
Integrative Case 4: Eco Plastics Company
Chapter8
RiskandReturn
Instructors Resources
Overview
Thischapterfocusesonthefundamentalsoftheriskandreturnrelationshipofassetsandtheirvaluation.
Forthesingleassetheldinisolation,riskismeasuredwiththeprobabilitydistributionanditsassociated
statistics:themean,thestandarddeviation,andthecoefficientofvariation.Theconceptofdiversification
isexaminedbymeasuringtheriskofaportfolioofassetsthatareperfectlypositivelycorrelated,perfectly
negativelycorrelated,andthosethatareuncorrelated.Next,thechapterlooksatinternationaldiversification
anditseffectonrisk.TheCapitalAssetPricingModel(CAPM)isthenpresentedasavaluationtoolfor
2012PearsonEducation,Inc.PublishingasPrenticeHall
Chapter8RiskandReturn145
securitiesandasageneralexplanationoftheriskreturntradeoffinvolvedinalltypesoffinancial
transactions.Chapter8highlightstheimportanceofunderstandingtherelationshipofriskandreturn
whenmakingprofessionalandpersonaldecisions.
Suggested Answer to Opener in Review Question

FortheCloseFundandtheFTSE,calculatetheaverageannualreturnanditsstandarddeviation.
Whatarethegeneralpatternsthatyousee?ProvideonereasonwhytheperformanceoftheFTSE
differsfromthatoftheCloseFund.
TheCloseFundsaveragewas61.6%anditsstandarddeviationis162.6%.TheFTSEaveragereturnwas
2.2%,anditsstandarddeviationis26.8%.TheFTSEhasaloweraveragereturnandlessvolatilitythan
theCloseFund.Theprimaryreasonforthedifferenceisthatsmallstocks(whichiswhattheCloseFund
investsin)generallyhavehigherreturnsandgreaterriskthanlargestocks(whicharetrackedbytheFTSE).
Althoughnotdirectlyaskedforintheproblem,itisusefultopointoutthemisinformationarisingfromusing
arithmeticmeanreturns.Themeanreturnisthesumofaseriesofnumbersdividedbythenumberofvalues,
andisappropriatewhenvaluesareindependentevents,suchastheaveragetestscoreinaclassroom.In
investmentreturns,thevaluesarenotindependentofeachother.Ifyouloseatonofmoneyoneyear,you
havemuchlesstoinvestthefollowingyear.Hence,thegeometricreturnisabettermeasureofthereturn
neededtoequateyourcashinflowsandoutflows.Specifically,thegeometricmeanreturnsforthesethree
yearsare12.1%fortheCloseFundand4.9%fortheFTSE.
Answers to Review Questions

1. Riskisdefinedasthechanceoffinancialloss,asmeasuredbythevariabilityofexpectedreturns
associatedwithagivenasset.Adecisionmakershouldevaluateaninvestmentbymeasuringthe
chanceofloss,orrisk,andcomparingtheexpectedrisktotheexpectedreturn.Someassetsare
consideredriskfree;themostcommonexamplesareU.S.Treasuryissues.
2. Thereturnonaninvestment(totalgainorloss)isthechangeinvalueplusanycashdistributionsover
adefinedtimeperiod.Itisexpressedasapercentofthebeginningoftheperiodinvestment.The
formulais:
Return
[(endingvalue initialvalue) cashdistribution]

initialvalue
Realizedreturnrequirestheassettobepurchasedandsoldduringthetimeperiodsthereturnis
measured.Unrealizedreturnisthereturnthatcouldhavebeenrealizediftheassethadbeen
purchasedandsoldduringthetimeperiodthereturnwasmeasured.
3. a.
Theriskaversefinancialmanagerrequiresanincreaseinreturnforagivenincreaseinrisk.
b. Theriskneutralmanagerrequiresnochangeinreturnforanincreaseinrisk.
c.
Theriskseekingmanageracceptsadecreaseinreturnforagivenincreaseinrisk.
Mostfinancialmanagersareriskaverse.
4. Scenarioanalysisevaluatesassetriskbyusingmorethanonepossiblesetofreturnstoobtainasense
ofthevariabilityofoutcomes.Therangeisfoundbysubtractingthepessimisticoutcomefromthe
optimisticoutcome.Thelargertherange,thegreatertheriskassociatedwiththeasset.
5. Thedecisionmakercangetanestimateofprojectriskbyviewingaplotoftheprobabilitydistribution,
whichrelatesprobabilitiestoexpectedreturnsandshowsthedegreeofdispersionofreturns.The
morespreadoutthedistribution,thegreaterthevariabilityorriskassociatedwiththereturnstream.
6. Thestandarddeviationofadistributionofassetreturnsisanabsolutemeasureofdispersionofrisk
aroundthemeanorexpectedvalue.Ahigherstandarddeviationindicatesagreaterprojectrisk.
Withalargerstandarddeviation,thedistributionismoredispersedandtheoutcomeshaveahigher
variability,resultinginhigherrisk.
7. Thecoefficientofvariationisanotherindicatorofassetrisk;however,thismeasuresrelativedispersion.
Itiscalculatedbydividingthestandarddeviationbytheexpectedvalue.Thecoefficientofvariation
indicateshowvolatileanassetsreturnsarerelativetoitsaverageorexpectedreturn.Therefore,the
coefficientofvariationisabetterbasisthanthestandarddeviationforcomparingriskofassetswith
differingexpectedreturns.
8. Anefficientportfolioisonethatmaximizesreturnforagivenrisklevelorminimizesriskforagiven
levelofreturn.Returnofaportfolioistheweightedaverageofreturnsontheindividualcomponent
assets:
n
rp w j rj
j 1
where:
147Gitman/ZutterPrinciplesofManagerialFinance,Thirteenth Edition
n numberofassets
wj weightofindividualassets
^rjexpectedreturns
Thestandarddeviationofaportfolioisnottheweightedaverageofcomponentstandarddeviations;
theriskoftheportfolioasmeasuredbythestandarddeviationwillbesmaller.Itiscalculatedby
applyingthestandarddeviationformulatotheportfolioassets:
rp
(ri r )2
i 1 ( n 1)
n
9. Thecorrelationbetweenassetreturnsisimportantwhenevaluatingtheeffectofanewassetonthe
portfoliosoverallrisk.Returnsondifferentassetsmovinginthesamedirectionarepositively
correlated,whilethosemovinginoppositedirectionsarenegativelycorrelated.Assetswithhigh
positivecorrelationincreasethevariabilityofportfolioreturns;assetswithhighnegativecorrelation
reducethevariabilityofportfolioreturns.Whennegativelycorrelatedassetsarebroughttogether
throughdiversification,thevariabilityoftheexpectedreturnfromtheresultingcombinationcanbe
lessthanthevariabilityorriskoftheindividualassets.Whenoneassethashighreturns,theothers
returnsarelowandviceversa.Therefore,theresultofdiversificationistoreduceriskbyprovidinga
patternofstablereturns.
Diversificationofriskintheassetselectionprocessallowstheinvestortoreduceoverallriskby
combiningnegativelycorrelatedassetssothattheriskoftheportfolioislessthantheriskofthe
individualassetsinit.Evenifassetsarenotnegativelycorrelated,thelowerthepositivecorrelation
betweenthem,thelowertheirresultingportfolioreturnvariability.
10. Theinclusionofforeignassetsinadomesticcompanysportfolioreducesriskfortworeasons.When
returnsfromforeigncurrencydenominatedassetsaretranslatedintodollars,thecorrelationofreturns
oftheportfoliosassetsisreduced.Also,iftheforeignassetsareincountriesthatarelesssensitiveto
theU.S.businesscycle,theportfoliosresponsetomarketmovementsisreduced.
Whenthedollarappreciatesrelativetoothercurrencies,thedollarvalueofaforeigncurrency
denominatedportfoliodeclinesandresultsinlowerreturnsindollarterms.Ifthisappreciationisdue
tobetterperformanceoftheU.S.economy,foreigncurrencydenominatedportfoliosgenerallyhave
lowerreturnsinlocalcurrencyaswell,furthercontributingtoreducedreturns.
Politicalrisksresultfrompossibleactionsbythehostgovernmentthatareharmfultoforeign
investorsorpossiblepoliticalinstabilitythatcouldendangerforeignassets.Thisformofriskis
particularlyhighindevelopingcountries.Companiesdiversifyinginternationallymayhaveassets
seizedorthereturnofprofitsblocked.
11. Thetotalriskofasecurityisthecombinationofnondiversifiableriskanddiversifiablerisk.
Diversifiableriskreferstotheportionofanassetsriskattributabletofirmspecific,randomevents
(strikes,litigation,lossofkeycontracts,etc.)thatcanbeeliminatedbydiversification.
Nondiversifiableriskisattributabletomarketfactorsaffectingallfirms(war,inflation,political
events,etc.).Somearguethatnondiversifiableriskistheonlyrelevantriskbecausediversifiablerisk
canbeeliminatedbycreatingaportfolioofassetsthatarenotperfectlypositivelycorrelated.
12. Betameasuresnondiversifiablerisk.Itisanindexofthedegreeofmovementofanassetsreturnin
responsetoachangeinthemarketreturn.Thebetacoefficientforanassetcanbefoundbyplotting
theassetshistoricalreturnsrelativetothereturnsforthemarket.Byusingstatisticaltechniques,the
characteristiclineisfittothedatapoints.Theslopeofthislineisbeta.Betacoefficientsfor
activelytradedstocksarepublishedintheValueLineInvestmentSurvey,inbrokeragereports,and
severalonlinesites.Thebetaofaportfolioiscalculatedbyfindingtheweightedaverageofthebetas
oftheindividualcomponentassets.
13. Theequationforthecapitalassetpricingmodelis:
rjRF[bj(rmRF)],
where:
rj therequired(orexpected)returnonassetj
RF therateofreturnrequiredonariskfreesecurity(aU.S.Treasurybill)
bj thebetacoefficientorindexofnondiversifiable(relevant)riskforassetj
rm therequiredreturnonthemarketportfolioofassets(themarketreturn)
Thesecuritymarketline(SML)isagraphicalpresentationoftherelationshipbetweentheamountof
systematicriskassociatedwithanassetandtherequiredreturn.Systematicriskismeasuredbybeta
andisonthehorizontalaxis,whiletherequiredreturnisontheverticalaxis.
14. a.
Ifthereisanincreaseininflationaryexpectations,thesecuritymarketlinewillshowaparallel
shiftupwardinanamountequaltotheexpectedincreaseininflation.Therequiredreturnfora
givenlevelofriskwillalsorise.
b. TheslopeoftheSML(thebetacoefficient)willbelesssteepifinvestorsbecomelessrisk
averse,andalowerlevelofreturnwillberequiredforeachlevelofrisk.
Suggested Answer to Global Focus Box:

An International Flavor to Risk Reduction
Internationalmutualfundsdonotincludeanydomesticassets,whereasglobalmutualfundsinclude
bothforeignanddomesticassets.HowmightthisdifferenceaffecttheircorrelationwithU.S.equity
mutualfunds?
Thedifferencebetweenglobalfundsandinternationalfundsisthatglobalfundscaninvestinstocksand
bondsaroundtheworld,includingU.S.securities,whereasinternationalfundsinvestinstocksandbonds
aroundtheworldbutnotU.Ssecurities.Therefore,globalfundsaremorelikelytobecorrelatedwithU.S.
equitymutualfunds,sinceasignificantportionoftheirportfoliosarelikelytobeU.S.equities.Aninvestor
seekingincreasedinternationaldiversificationinaportfolioshouldconsiderinternationalfundsoverglobal
fundsorincreasetheportionoftheportfoliodevotedtoglobalfundsifseekingdiversificationthrough
globalfunds.
Suggested Answer to Focus on Ethics Box:

If it Sounds Too Good to be True Then it Probably is
Whataresomehazardsofallowinginvestorstopursueclaimsbasedontheirmostrecentaccounts
statements?
Allowingclaimsbasedonfraudulentstatementsreducesinvestorsincentivetoperformduediligence.If
investorsareallowedtoprofitfromfraudengineeredbytheirinvestmentmanager,becomingavictim
offraudcouldbecomeadesiredoutcome,asinvestorsprimaryincentivewouldbetosecurethelargest
possiblereturn,legitimateornot.
Answers to Warm-Up Exercises
E81.
Totalannualreturn
Answer: ($0$12,000$10,000)$10,000$2,000$10,00020%
Logistics,Inc.doubledtheannualrateofreturnpredictedbytheanalyst.Thenegativenet
incomeisirrelevanttotheproblem.
E82.
Expectedreturn
Answer:
Analyst
1
2
3
4
Total
E83.
Probability
Return
0.35
0.05
0.20
0.40
1.00
5%
5%
10%
3%
Expectedreturn
WeightedValue
1.75%
0.25%
2.0%
1.2%
4.70%
Comparingtheriskoftwoinvestments
Answer: CV10.100.150.6667 CV20.050.120.4167
Basedsolelyonstandarddeviations,Investment2haslowerriskthanInvestment1.Basedon
coefficientsofvariation,Investment2isstilllessriskythanInvestment1.Sincethetwo
investmentshavedifferentexpectedreturns,usingthecoefficientofvariationtoassessriskis
betterthansimplycomparingstandarddeviationsbecausethecoefficientofvariationconsiders
therelativesizeoftheexpectedreturnsofeachinvestment.
E84.
Computingtheexpectedreturnofaportfolio
Answer: rp(0.450.038)(0.40.123)(0.150.174)
(0.0171)(0.0492)(0.02610.09249.24%
Theportfolioisexpectedtohaveareturnofapproximately9.2%.
E85.
Calculatingaportfoliobeta
Answer:
Beta(0.201.15)(0.100.85)(0.151.60)(0.201.35)(0.351.85)
0.23000.08500.24000.27000.64751.4725
E86.
Calculatingtherequiredrateofreturn
Answer:
a. Requiredreturn0.051.8(0.100.05)0.050.090.14
b. Requiredreturn0.051.8(0.130.05)0.050.1440.194
c.
Althoughtheriskfreeratedoesnotchange,asthemarketreturnincreases,therequired
returnontheassetrisesby180%ofthechangeinthemarketsreturn.
Solutions to Problems
rt =
P81.
(Pt Pt 1 Ct )
Pt1
Rateofreturn:
LG1;Basic
a.
($21,000 $20,000 $1,500)

12.50%
$20,000
($55,000 $55,000 $6,800)

12.36%
$55,000
InvestmentX:Return
InvestmentY:Return
b. InvestmentXshouldbeselectedbecauseithasahigherrateofreturnforthesamelevel
ofrisk.
rt =
P82.
(Pt Pt 1 Ct )
Pt1
Returncalculations:
LG1;Basic
Investment
P83.
Calculation
rt(%)
($1,100$800$100)$800
25.00
($118,000$120,000$15,000)$120,000
10.83
($48,000$45,000$7,000)$45,000
22.22
($500$600$80)$600
3.33
($12,400$12,500$1,500)$12,500
11.20
Riskpreferences
LG1;Intermediate
a.
TheriskneutralmanagerwouldacceptInvestmentsXandYbecausethesehavehigher
returnsthanthe12%requiredreturnandtheriskdoesntmatter.
b. TheriskaversemanagerwouldacceptInvestmentXbecauseitprovidesthehighestreturn
andhasthelowestamountofrisk.InvestmentXoffersanincreaseinreturnfortakingon
moreriskthanwhatthefirmcurrentlyearns.
c.
TheriskseekingmanagerwouldacceptInvestmentsYandZbecauseheorsheiswillingto
takegreaterriskwithoutanincreaseinreturn.
d. Traditionally,financialmanagersareriskaverseandwouldchooseInvestmentX,sinceit
providestherequiredincreaseinreturnforanincreaseinrisk.
P84.
Riskanalysis
LG2;Intermediate
a.
Expansion
Range
24%16%8%
30%10%20%
b. ProjectAislessrisky,sincetherangeofoutcomesforAissmallerthantherangefor
ProjectB.
c.
Sincethemostlikelyreturnforbothprojectsis20%andtheinitialinvestmentsareequal,the
answerdependsonyourriskpreference.
d. Theanswerisnolongerclear,sinceitnowinvolvesariskreturntradeoff.ProjectBhasa
slightlyhigherreturnbutmorerisk,whileAhasbothlowerreturnandlowerrisk.
P85.
Riskandprobability
LG2;Intermediate
a.
Camera
Range
30%20%10%
35%15%20%
b.
Possible
Outcomes
Probability
ExpectedReturn
Weighted
CameraR
CameraS
c.
Pri
ri
Value(%)(riPri)
Pessimistic
0.25
20
5.00%
Mostlikely
0.50
25
12.50%
Optimistic
0.25
30
7.50%
1.00
Expectedreturn
25.00%
Pessimistic
0.20
15
3.00%
Mostlikely
0.55
25
13.75%
Optimistic
0.25
35
8.75%
1.00
Expectedreturn
25.50%
CameraSisconsideredmoreriskythanCameraRbecauseithasamuchbroaderrangeof
outcomes.TheriskreturntradeoffispresentbecauseCameraSismoreriskyandalso
providesahigherreturnthanCameraR.
P86.
Barchartsandrisk
LG2;Intermediate
a.
b.
Market
Acceptance
LineJ
Probability
Pri
WeightedValue
(riPri)
VeryPoor
0.05
0.0075
0.000375
Poor
0.15
0.0125
0.001875
Average
0.60
0.0850
0.051000
Good
0.15
0.1475
0.022125
Excellent
0.05
0.1625
0.008125
1.00
LineK
ExpectedReturn
ri
VeryPoor
0.05
Expectedreturn
0.010
0.083500
0.000500
Poor
0.15
0.025
0.003750
Average
0.60
0.080
0.048000
Good
0.15
0.135
0.020250
Excellent
0.05
0.150
0.007500
1.00
c.
0.080000
LineKappearslessriskyduetoaslightlytighterdistributionthanlineJ,indicatingalower
rangeofoutcomes.
CV
P87.
Expectedreturn
r
r
Coefficientofvariation:
LG2;Basic
a.
CVA
7%
0.3500
20%
CVB
9.5%
0.4318
22%
CVC
6%
0.3158
19%
CVD
5.5%
0.3438
16%
b. AssetChasthelowestcoefficientofvariationandistheleastriskyrelativetotheotherchoices.
P88.
Standarddeviationversuscoefficientofvariationasmeasuresofrisk
LG2;Basic
a.
ProjectAisleastriskybasedonrangewithavalueof0.04.
b. Thestandarddeviationmeasurefailstotakeintoaccountboththevolatilityandthereturnof
theinvestment.Investorswouldpreferhigherreturnbutlessvolatility,andthecoefficientof
variationprovicesameasurethattakesintoaccountbothaspectsofinvestorspreferences.
ProjectDhasthelowestCV,soitistheleastriskyinvestmentrelativetothereturnprovided.
c.
CVA
0.029
0.2417
0.12
CVB
0.032
0.2560
0.125
CVC
0.035
0.2692
0.13
CVD
0.030
0.2344
0.128
InthiscaseProjectDisthebestalternativesinceitprovidestheleastamountofriskforeach
percentofreturnearned.Coefficientofvariationisprobablythebestmeasureinthisinstance
sinceitprovidesastandardizedmethodofmeasuringtheriskreturntradeoffforinvestments
withdifferingreturns.
P89.
Personalfinance:Rateofreturn,standarddeviation,coefficientofvariation
LG2;Challenge
a.
StockPrice
Variance
Year
Beginnin
g
End
2009
14.36
21.55
50.07%
0.0495
2010
21.55
64.78
200.60%
1.6459
2011
64.78
72.38
11.73%
0.3670
2012
72.38
91.80
26.83%
0.2068
Returns
(ReturnAverageReturn)2
b.
c.
Averagereturn
Sumofvariances
72.31%
2.2692
3
Sampledivisor(n1)
0.7564
Variance
86.97%
d.
e.
1.20
Standarddeviation
Coefficientofvariation
ThestockpriceofHiTech,Inc.hasdefinitelygonethroughsomemajorpricechanges
overthistimeperiod.Itwouldhavetobeclassifiedasavolatilesecurityhavingan
upwardpricetrendoverthepast4years.NotehowcomparingsecuritiesonaCVbasis
allowstheinvestortoputthestockinproperperspective.Thestockisriskierthanwhat
MikenormallybuysbutifhebelievesthatHiTech,Inc.willcontinuetorisethenhe
shouldincludeit.Thecoefficientofvariation,however,isgreaterthanthe0.90target.
P810. Assessingreturnandrisk
LG2;Challenge
a.
Project257
(1) Range:1.00(.10)1.10
n
r ri Pri
i =1
(2) Expectedreturn:
ExpectedReturn
n
r ri Pri
i1
RateofReturn
Probability
WeightedValue
ri
Pr i
ri Pr i
.10
0.01
0.001
0.10
0.04
0.004
0.20
0.05
0.010
0.30
0.10
0.030
0.40
0.15
0.060
0.45
0.30
0.135
0.50
0.15
0.075
0.60
0.10
0.060
0.70
0.05
0.035
0.80
0.04
0.032
1.00
0.01
0.010
1.00
(r r )
i 1
0.450
2
Pri
(3) Standarddeviation:
ri
ri r
( ri r )
Pr i
2
( ri r )
Pr i
0.10
0.450
0.550
0.3025
0.01
0.003025
0.10
0.450
0.350
0.1225
0.04
0.004900
0.20
0.450
0.250
0.0625
0.05
0.003125
0.30
0.450
0.150
0.0225
0.10
0.002250
0.40
0.450
0.050
0.0025
0.15
0.000375
0.45
0.450
0.000
0.0000
0.30
0.000000
0.50
0.450
0.050
0.0025
0.15
0.000375
0.60
0.450
0.150
0.0225
0.10
0.002250
0.70
0.450
0.250
0.0625
0.05
0.003125
0.80
0.450
0.350
0.1225
0.04
0.004900
1.00
0.450
0.550
0.3025
0.01
0.003025
0.027350
Project 257 0.027350 0.165378

CV
(4)
0.165378
0.3675
0.450
Project432
(1) Range:0.500.100.40
n
r ri Pri
i 1
(2) Expectedreturn:
ExpectedReturn
RateofReturn
ri
Probability
Pr i
WeightedValue
0.10
0.05
0.0050
0.15
0.10
0.0150
0.20
0.10
0.0200
0.25
0.15
0.0375
0.30
0.20
0.0600
0.35
0.15
0.0525
0.40
0.10
0.0400
0.45
0.10
0.0450
0.50
0.05
0.0250
r ri Pri
i =1
ri Pri
1.00
0.300
n
(r r )
i 1
Pri
(3) Standarddeviation:
ri
ri r
( ri r )2
Pri
( ri r )2 Pri
0.10
0.300
0.20
0.0400
0.05
0.002000
0.15
0.300
0.15
0.0225
0.10
0.002250
0.20
0.300
0.10
0.0100
0.10
0.001000
0.25
0.300
0.05
0.0025
0.15
0.000375
0.30
0.300
0.00
0.0000
0.20
0.000000
0.35
0.300
0.05
0.0025
0.15
0.000375
0.40
0.300
0.10
0.0100
0.10
0.001000
0.45
0.300
0.15
0.0225
0.10
0.002250
0.50
0.300
0.20
0.0400
0.05
0.002000
0.011250
Project432
CV
(4)
0.011250
0.106066
0.106066
0.3536
0.300
b. BarCharts
c.
Summarystatistics
Range
(r )
Project257
Project432
1.100
0.400
0.450
0.300
0.165
0.106
0.3675
0.3536
Expectedreturn
( r )
Standarddeviation
Coefficientofvariation(CV)
SinceProjects257and432havedifferingexpectedvalues,thecoefficientofvariationshould
bethecriterionbywhichtheriskoftheassetisjudged.SinceProject432hasasmallerCV,it
istheopportunitywithlowerrisk.
P811. Integrativeexpectedreturn,standarddeviation,andcoefficientofvariation
LG2;Challenge
r ri Pri
i 1
a.
Expectedreturn:
ExpectedReturn
AssetF
RateofReturn
ri
Probability
Pr i
WeightedValue
0.40
0.10
0.04
0.10
0.20
0.02
0.00
0.40
0.00
0.05
0.20
0.01
0.10
0.10
0.01
ri Pri
r ri Pri
i 1
0.04
Continued
AssetG
0.35
0.40
0.14
0.10
0.30
0.03
0.20
0.30
0.06
0.11
AssetH
0.40
0.10
0.04
0.20
0.20
0.04
0.10
0.40
0.04
0.00
0.20
0.00
0.20
0.10
0.02
0.10
AssetGprovidesthelargestexpectedreturn.
(r r )
i 1
xPri
b. Standarddeviation:
ri r
( ri r )
Pr i
AssetF
0.40 0.04 0.36
0.1296
0.10
0.01296
0.10 0.04 0.06
0.0036
0.20
0.00072
0.00 0.040.04
0.0016
0.40
0.00064
0.05 0.040.09
0.0081
0.20
0.00162
0.10 0.040.14
0.0196
0.10
0.00196
0.01790
0.1338
0.35 0.11 .24
0.0576
0.40
0.02304
0.10 0.110.01
0.0001
0.30
0.00003
0.20 0.110.31
0.0961
0.30
0.02883
0.05190
0.2278
AssetG
0.40 0.10 .30
0.0900
0.10
0.009
0.20 0.10 .10
0.0100
0.20
0.002
0.10 0.10 0.00
0.0000
0.40
0.000
0.00 0.100.10
0.0100
0.20
0.002
0.20 0.100.30
0.0900
0.10
0.009
0.022
0.1483
AssetH
Basedonstandarddeviation,AssetGappearstohavethegreatestrisk,butitmustbe
measuredagainstitsexpectedreturnwiththestatisticalmeasurecoefficientofvariation,since
thethreeassetshavedifferingexpectedvalues.Anincorrectconclusionabouttheriskofthe
assetscouldbedrawnusingonlythestandarddeviation.
Coefficientofvariation =
standarddeviation( )
expectedvalue
c.
CV
0.1338
3.345
0.04
CV
0.2278
2.071
0.11
CV
0.1483
1.483
0.10
AssetF:
AssetG:
AssetH:
Asmeasuredbythecoefficientofvariation,AssetFhasthelargestrelativerisk.
P812. Normalprobabilitydistribution
LG2;Challenge
r r
a.
Coefficientofvariation:CV
Solvingforstandarddeviation: 0.75r0.189
r0.750.1890.14175
b. (1) 68%oftheoutcomeswillliebetween1standarddeviationfromtheexpectedvalue:
1 0.189 0.14175 0.33075
1 0.189 0.14175 0.04725
(2) 95%oftheoutcomeswillliebetween2standarddeviationsfromtheexpectedvalue:
2 0.189 (2 0.14175) 0.4725
2 0.189 (2 0.14175) 0.0945
(3) 99%oftheoutcomeswillliebetween3standarddeviationsfromtheexpectedvalue:
3 0.189 (3 0.14175) 0.61425
3 0.189 (3 0.14175) 0.23625
c.
P813. Personalfinance:Portfolioreturnandstandarddeviation
LG3;Challenge
a.
Expectedportfolioreturnforeachyear:rp(wLrL)(wMrM)
Expected
Return
AssetM
AssetL
Year
(wLrL)
2013
(14%0.405.6%)
(20%0.6012.0%)
17.6%
2014
(14%0.405.6%)
(18%0.6010.8%)
16.4%
2015
(16%0.406.4%)
(16%0.609.6%)
16.0%
2016
(17%0.406.8%)
(14%0.608.4%)
15.2%
2017
(17%0.406.8%)
(12%0.607.2%)
14.0%
2018
(19%0.407.6%)
(10%0.606.0%)
13.6%
rp
b. Portfolioreturn:
rp
j 1
(wMrM)
PortfolioReturn
rp
rj
17.6 16.4 16.0 15.2 14.0 13.6

15.467 15.5%
6
rp
c.
(ri r )2
i 1 ( n 1)
n
Standarddeviation:
(17.6% 15.5%)2 (16.4% 15.5%)2 (16.0% 15.5%)2
(15.2% 15.5%)2 (14.0% 15.5%)2 (13.6% 15.5%)2
rp
6 1
(2.1%)2 (0.9%)2 (0.5%)2
2
2
2
(0.3%) (1.5%) (1.9%)
rp
5
rp
(.000441 0.000081 0.000025 0.000009 0.000225 0.000361)

5
rp
0.001142
0.000228% 0.0151 1.51%
5
d. Theassetsarenegativelycorrelated.
e.
Combiningthesetwonegativelycorrelatedassetsreducesoverallportfoliorisk.
P814. Portfolioanalysis
LG3;Challenge
a.
Expectedportfolioreturn:
Alternative1:100%AssetF
rp
16% 17% 18% 19%

17.5%
4
Alternative2:50%AssetF50%AssetG
Year
AssetF
AssetG
(wFrF)
(wGrG)
PortfolioReturn
rp
2013
(16%0.508.0%)
(17%0.508.5%)
16.5%
2014
(17%0.508.5%)
(16%0.508.0%)
16.5%
2015
(18%0.509.0%)
(15%0.507.5%)
16.5%
2016
(19%0.509.5%)
(14%0.507.0%)
16.5%
rp
16.5% 16.5% 16.5% 16.5%

16.5%
4
Alternative3:50%AssetF50%AssetH
Year
AssetF
AssetH
(wFrF)
(wHrH)
PortfolioReturn
rp
2013
(16%0.508.0%)
(14%0.507.0%)
15.0%
2014
(17%0.508.5%)
(15%0.507.5%)
16.0%
2015
(18%0.509.0%)
(16%0.508.0%)
17.0%
2016
(19%0.509.5%)
(17%0.508.5%)
18.0%
rp
15.0% 16.0% 17.0% 18.0%

16.5%
4
rp
(ri r )2
i 1 ( n 1)
n
b. Standarddeviation:
(1)
[(16.0% 17.5%)2 (17.0% 17.5%)2 (18.0% 17.5%)2 (19.0% 17.5%)2 ]

4 1
[(1.5%)2 (0.5%)2 (0.5%)2 (1.5%)2 ]

3
(0.000225 0.000025 0.000025 0.000225)

3
0.0005
.000167 0.01291 1.291%
3
(2)
FG
[(16.5% 16.5%)2 (16.5% 16.5%) 2 (16.5% 16.5%) 2 (16.5% 16.5%)2 ]

4 1
FG
[(0)2 (0)2 (0)2 (0)2 ]

3
FG 0
(3)
FH
[(15.0% 16.5%)2 (16.0% 16.5%) 2 (17.0% 16.5%) 2 (18.0% 16.5%)2 ]

4 1
FH
[(1.5%)2 (0.5%)2 (0.5%)2 (1.5%)2 ]

3
FH
[(0.000225 0.000025 0.000025 0.000225)]

3
FH
0.0005
0.000167 0.012910 1.291%
3
r r
c.
Coefficientofvariation:CV
CVF
1.291%
0.0738
17.5%
CVFG
0
0
16.5%
CVFH
1.291%
0.0782
16.5%
d. Summary:
rp:ExpectedValue
ofPortfolio
rp
CVp
0.0738
Alternative1(F)
17.5%
1.291%
Alternative2(FG)
16.5%
Alternative3(FH)
16.5%
1.291%
0.0
0.0782
Sincetheassetshavedifferentexpectedreturns,thecoefficientofvariationshouldbeusedto
determinethebestportfolio.Alternative3,withpositivelycorrelatedassets,hasthehighest
coefficientofvariationandthereforeistheriskiest.Alternative2isthebestchoice;itis
perfectlynegativelycorrelatedandthereforehasthelowestcoefficientofvariation.
P815. Correlation,risk,andreturn
LG4;Intermediate
a.
(1) Rangeofexpectedreturn:between8%and13%
(2) Rangeoftherisk:between5%and10%
b. (1) Rangeofexpectedreturn:between8%and13%
(2) Rangeoftherisk:0risk10%
c.
(1) Rangeofexpectedreturn:between8%and13%
(2) Rangeoftherisk:0risk10%
P816. Personalfinance:Internationalinvestmentreturns
LG1,4;Intermediate
24,750 20,500 4,250
0.20732 20.73%
20,500
20,500
a.
Returnpesos
Purchaseprice
Priceinpesos
20.50
$2.22584 1,000shares $2,225.84

Pesosperdollar 9.21
b.
Salesprice
Priceinpesos
24.75
$2.51269 1,000shares $2,512.69

Pesosperdollar 9.85
2,512.69 2,225.84
286.85
0.12887 12.89%
2,225.84
2,225.84
c.
Returnpesos
d. Thetworeturnsdifferduetothechangeintheexchangeratebetweenthepesoandthedollar.
Thepesohaddepreciation(andthusthedollarappreciated)betweenthepurchasedateand
thesaledate,causingadecreaseintotalreturn.Theanswerinpartcisthemoreimportant
ofthetworeturnsforJoe.Aninvestorinforeignsecuritieswillcarryexchangeraterisk.
P817. Total,nondiversifiable,anddiversifiablerisk
LG5;Intermediate
a.andb.
c.
Onlynondiversifiableriskisrelevantbecause,asshownbythegraph,diversifiableriskcan
bevirtuallyeliminatedthroughholdingaportfolioofatleast20securitiesthatarenotpositively
correlated.DavidTalbotsportfolio,assumingdiversifiableriskcouldnolongerbereduced
byadditionstotheportfolio,has6.47%relevantrisk.
P818. Graphicderivationofbeta
LG5;Intermediate
a.
Beta
b. Toestimatebeta,theriseoverrunmethodcanbeused:
Rise Y
Run X
Takingthepointsshownonthegraph:
BetaA
Y 12 9 3
0.75
X 8 4 4
BetaB
Y 26 22 4
1.33
X 13 10 3
Afinancialcalculatorwithstatisticalfunctionscanbeusedtoperformlinearregression
analysis.Thebeta(slope)oflineAis0.79;oflineB,1.379.
c.
Withahigherbetaof1.33,AssetBismorerisky.Itsreturnwillmove1.33timesforeachone
pointthemarketmoves.AssetAsreturnwillmoveatalowerrate,asindicatedbyitsbeta
coefficientof0.75.
P819. Graphicalderivationandinterpretationofbeta
LG5;Intermediate
a. Withareturnrangefrom60%to60%,BiotechCures,exhibitedinPanelB,isthemore
riskystock.Returnsarewidelydispersedinthisreturnrangeregardlessofmarketconditions.
Bycomparison,thereturnsofPanelAsCyclicalIndustriesIncorporatedonlyrangefrom
about40%to40%.Thereislessdispersionofreturnswithinthisreturnrange.
b. ThereturnsonCyclicalIndustriesIncorporatedsstockaremorecloselycorrelatedwith
themarketsperformance.Hence,mostofCyclicalIndustriesreturnsfitaroundtheupward
slopingleastsquaresregressionline.Bycomparison,BiotechCureshasearnedreturns
approaching60%duringaperiodwhentheoverallmarketexperiencedaloss.Evenifthe
marketisup,BiotechCureshaslostalmosthalfofitsvalueinsomeyears.
c. Onastandalonebasis,BiotechCuresCorporationisriskier.However,ifaninvestorwas
seekingtodiversifytheriskoftheircurrentportfolio,theunique,nonsystematicperformance
ofBiotechCuresCorporationmakesitagoodaddition.Otherconsiderationswouldbethe
meanreturnforboth(hereCyclicalIndustrieshasahigherreturnwhentheoverallmarket
returniszero),expectationsregardingtheoverallmarketperformance,andleveltowhichone
canusehistoricreturnstoaccuratelyforecaststockpricebehavior.
P820. Interpretingbeta
LG5;Basic
Effectofchangeinmarketreturnonassetwithbetaof1.20:
a.
1.20(15%) 18.0%increase
b. 1.20(8%) 9.6%decrease
c.
1.20(0%) nochange
d. Theassetismoreriskythanthemarketportfolio,whichhasabetaof1.Thehigherbeta
makesthereturnmovemorethanthemarket.
P821. Betas
LG5;Basic
a.andb.
Asset
Beta
Increasein
MarketReturn
0.50
0.10
ExpectedImpact
onAssetReturn
0.05
Decreasein
MarketReturn
Impacton
AssetReturn
0.10
0.05
c.
1.60
0.10
0.16
0.10
0.16
0.20
0.10
0.02
0.10
0.02
0.90
0.10
0.09
0.10
0.09
AssetBshouldbechosenbecauseitwillhavethehighestincreaseinreturn.
d. AssetCwouldbetheappropriatechoicebecauseitisadefensiveasset,movinginopposition
tothemarket.Inaneconomicdownturn,AssetCsreturnisincreasing.
P822. Personalfinance:Betasandriskrankings
LG5;Intermediate
a.
Mostrisky
Leastrisky
Stock
Beta
1.40
0.80
0.30
b.andc.
Asset
Beta
Increasein
MarketReturn
ExpectedImpact
onAssetReturn
Decreasein
MarketReturn
Impacton
AssetReturn
0.80
0.12
0.096
0.05
0.04
1.40
0.12
0.168
0.05
0.07
0.30
0.12
0.036
0.05
0.015
d. Inadecliningmarket,aninvestorwouldchoosethedefensivestock,StockC.Whilethe
marketdeclines,thereturnonCincreases.
e.
Inarisingmarket,aninvestorwouldchooseStockB,theaggressivestock.Asthemarket
risesonepoint,StockBrises1.40points.
n
w
j 1
bj
P823. Personalfinance:Portfoliobetas:bp
LG5;Intermediate
a.
PortfolioA
PortfolioB
Asset
Beta
wA
wAbA
wB
wBbB
1.30
0.10
0.130
0.30
0.39
0.70
0.30
0.210
0.10
0.07
1.25
0.10
0.125
0.20
0.25
1.10
0.10
0.110
0.20
0.22
0.90
0.40
0.360
0.20
bA 0.935
bB
0.18
1.11
b. PortfolioAisslightlylessriskythanthemarket(averagerisk),whilePortfolioBismore
riskythanthemarket.PortfolioBsreturnwillmovemorethanPortfolioAsforagiven
increaseordecreaseinmarketreturn.PortfolioBisthemorerisky.
P824. Capitalassetpricingmodel(CAPM):rjRF[bj(rmRF)]
LG6;Basic
Case
rj
RF[bj(rmRF)]
8.9%
5% [1.30(8%5%)]
12.5%
8% [0.90(13%8%)]
8.4%
9% [0.20(12%9%)]
15.0%
10% [1.00(15%10%)]
8.4%
6% [0.60(10%6%)]
P825. Personalfinance:Betacoefficientsandthecapitalassetpricingmodel
LG5,6;Intermediate
TosolvethisproblemyoumusttaketheCAPMandsolveforbeta.Theresultingmodelis:
Beta
r RF
rm RF
Beta
10% 5% 5%
0.4545
16% 5% 11%
Beta
15% 5% 10%
0.9091
16% 5% 11%
Beta
18% 5% 13%
1.1818
16% 5% 11%
Beta
20% 5% 15%
1.3636
16% 5% 11%
a.
b.
c.
d.
e.
IfKatherineiswillingtotakeamaximumofaverageriskthenshewillbeabletohavean
expectedreturnofonly16%.(r5%1.0(16%5%)16%.)
P826. ManipulatingCAPM:rjRF[bj(rmRF)]
LG6;Intermediate
a.
rj 8%[0.90(12%8%)]
rj 11.6%
b. 15% RF[1.25(14%RF)]
RF 10%
c.
16% 9%[1.10(rm9%)]
rm 15.36%
d. 15% 10%[bj(12.5%10%)
bj 2
P827. Personalfinance:Portfolioreturnandbeta
LG1,3,5,6:Challenge
a.
bp(0.20)(0.80)(0.35)(0.95)(0.30)(1.50)(0.15)(1.25)
0.160.33250.450.18751.13
($20,000 $20,000) $1,600 $1,600
8%
$20,000
$20,000
($36,000 $35,000) $1,400 $2,400
6.86%
$35,000
$35,000
($34,500 $30,000) 0 $4,500
15%
$30,000
$30,000
($16,500 $15,000) $375 $1,875
12.5%
$15,000
$15,000
($107,000 $100,000) $3,375 $10,375
10.375%
$100,000
$100,000
b. rA
rB
rC
rD
c.
rP
d. rA4%[0.80(10%4%)]8.8%
rB4%[0.95(10%4%)]9.7%
rC4%[1.50(10%4%)]13.0%
rD4%[1.25(10%4%)]11.5%
e.
Ofthefourinvestments,onlyC(15%vs.13%)andD(12.5%vs.11.5%)hadactualreturns
thatexceededtheCAPMexpectedreturn(15%vs.13%).Theunderperformancecouldbe
duetoanyunsystematicfactorthatwouldhavecausedthefirmnotdoaswellasexpected.
Anotherpossibilityisthatthefirmscharacteristicsmayhavechangedsuchthatthebetaat
thetimeofthepurchaseoverstatedthetruevalueofbetathatexistedduringthatyear.Athird
explanationisthatbeta,asasinglemeasure,maynotcaptureallofthesystematicfactorsthat
causetheexpectedreturn.Inotherwords,thereiserrorinthebetaestimate.
P828. Securitymarketline,SML
LG6;Intermediate
a,b,andd.
c.
rjRF[bj(rmRF)]
AssetA
rj0.09[0.80(0.130.09)]
rj0.122
AssetB
rj0.09[1.30(0.130.09)]
rj0.142
d. AssetAhasasmallerrequiredreturnthanAssetBbecauseitislessrisky,basedonthebeta
of0.80forAssetAversus1.30forAssetB.ThemarketriskpremiumforAssetAis3.2%
(12.2%9%),whichislowerthanAssetBsmarketriskpremium(14.2%9%5.2%).
P829. Shiftsinthesecuritymarketline
LG6;Challenge
a,b,c,d.
b. rjRF[bj(rmRF)]
rA8%[1.1(12%8%)]
rA8%4.4%
rA12.4%
c.
rA6%[1.1(10%6%)]
rA6%4.4%
rA10.4%
d. rA8%[1.1(13%8%)]
rA8%5.5%
rA13.5%
e.
(1) Adecreaseininflationaryexpectationsreducestherequiredreturnasshowninthe
paralleldownwardshiftoftheSML.
(2) Increasedriskaversionresultsinasteeperslope,sinceahigherreturnwouldberequired
foreachlevelofriskasmeasuredbybeta.
P830. Integrativerisk,return,andCAPM
LG6;Challenge
a.
Project
rj
RF[bj(rmRF)]
rj
9%[1.5(14%9%)]
16.5%
rj
9%[0.75(14%9%)]
12.75%
rj
9%[2.0(14%9%)]
19.0%
rj
9%[0(14%9%)]
9.0%
rj
9%[(0.5)(14%9%)]
6.5%
b.andd.
c.
ProjectAis150%asresponsiveasthemarket.
ProjectBis75%asresponsiveasthemarket.
ProjectCistwiceasresponsiveasthemarket.
ProjectDisunaffectedbymarketmovement.
ProjectEisonlyhalfasresponsiveasthemarket,butmovesintheoppositedirectionasthe
market.
d. SeegraphfornewSML.
rA9%[1.5(12%9%)] 13.50%
rB9%[0.75(12%9%)] 11.25%
rC9%[2.0(12%9%)] 15.00%
rD9%[0(12%9%)]
9.00%
rE9%[0.5(12%9%)] 7.50%
e.
ThesteeperslopeofSMLbindicatesahigherriskpremiumthanSMLdforthesemarket
conditions.Wheninvestorriskaversiondeclines,investorsrequirelowerreturnsforany
givenrisklevel(beta).
P831. Ethicsproblem
LG1;Intermediate
Investorsexpectmanagerstotakeriskswiththeirmoney,soitisclearlynotunethicalfor
managerstomakeriskyinvestmentswithotherpeoplesmoney.However,managershaveaduty
tocommunicatetruthfullywithinvestorsabouttheriskthattheyaretaking.Portfoliomanagers
shouldnottakerisksthattheydonotexpecttogeneratereturnssufficienttocompensateinvestors
forthereturnvariability.
Case
Casestudiesareavailableonwww.myfinancelab.com.
Analyzing Risk and Return on Chargers Products Investments

Thiscaserequiresstudentstoreviewandapplytheconceptoftheriskreturntradeoffbyanalyzingtwo
possibleassetinvestmentsusingstandarddeviation,coefficientofvariation,andCAPM.
rt
a.
( Pt Pt 1 Ct )
Pt 1
Expectedrateofreturn:
AssetX:
Year
Cash
Flow(Ct)
Ending
Value(Pt)
Beginning
Value(Pt1)
Gain/
Loss
AnnualRate
ofReturn
2003
$1,000
$22,000
$20,000
$2,000
15.00%
2004
1,500
21,000
22,000
1,000
2.27
2005
1,400
24,000
21,000
3,000
20.95
2006
1,700
22,000
24,000
2,000
1.25
AssetX:(continued)
Year
Cash
Ending
Beginning
Flow(Ct)
Value(Pt)
Value(Pt1)
Gain/
Loss
AnnualRate
ofReturn
2007
1,900
23,000
22,000
1,000
13.18
2008
1,600
26,000
23,000
3,000
20.00
2009
1,700
25,000
26,000
1,000
2.69
2010
2,000
24,000
25,000
1,000
4.00
2011
2,100
27,000
24,000
3,000
21.25
2012
2,200
30,000
27,000
3,000
19.26
AverageexpectedreturnforAssetX11.74%
AssetY:
Cash
Ending
Beginning
Year
Flow(Ct)
Value(Pt)
Value(Pt1)
2003
$1,500
$20,000
$20,000
$0
2004
1,600
20,000
20,000
8.00
2005
1,700
21,000
20,000
1,000
13.50
2006
1,800
21,000
21,000
8.57
2007
1,900
22,000
21,000
1,000
13.81
Gain/
Loss
AnnualRate
ofReturn
7.50%
2008
2,000
23,000
22,000
1,000
13.64
2009
2,100
23,000
23,000
9.13
2010
2,200
24,000
23,000
1,000
13.91
2011
2,300
25,000
24,000
1,000
13.75
2012
2,400
25,000
25,000
9.60
AverageexpectedreturnforAssetY11.14%
(r r )
i 1
b.
( n 1)
AssetX:
Average
Return,r
Year
Return
ri
2003
15.00%
2004
2.27
11.74
9.47
0.008968
2005
20.95
11.74
9.21
0.008482
2006
1.25
11.74
12.99
0.016874
2007
13.18
11.74
1.44
0.000207
2008
20.00
11.74
8.26
0.006823
11.74%
( ri r )
( ri r )
3.26%
0.001063
AssetX:(continued)
Average
Return,r
Year
Return
ri
2009
2.69
11.74
9.05
0.008190
2010
4.00
11.74
7.74
0.005991
2011
21.25
11.74
9.51
0.009044
2012
19.26
11.74
7.52
0.005655
( ri r )
( ri r )
2
0.071297
CV
0.071297
0.07922 0.0890 8.90%
10 1
8.90%
0.76
11.74%
AssetY:
Return
ri
Average
Return,r
(ri r )
(ri r )
2003
7.50%
11.14%
3.64%
0.001325
2004
8.00
11.14
3.14
0.000986
2005
13.50
11.14
2.36
0.000557
2006
8.57
11.14
2.57
0.000660
2007
13.81
11.14
2.67
0.000713
2008
13.64
11.14
2.50
0.000625
Year
2009
9.13
11.14
2.01
0.000404
2010
13.91
11.14
2.77
0.000767
2011
13.75
11.14
2.61
0.000681
2012
9.60
11.14
1.54
0.000237
0.006955
CV
0.006955
0.0773 0.0278 2.78%
10 1
2.78%
0.25
11.14%
c.
Summarystatistics:
AssetX
AssetY
11.74%
11.14%
Standarddeviation
8.90%
2.78%
Coefficientofvariation
0.76
0.25
Expectedreturn
Comparingtheexpectedreturnscalculatedinparta,AssetXprovidesareturnof11.74%,only
slightlyabovethereturnof11.14%expectedfromAssetY.Thehigherstandarddeviationand
coefficientofvariationofInvestmentXindicatesgreaterrisk.Withjustthisinformation,itis
difficulttodeterminewhetherthe0.60%differenceinreturnisadequatecompensationforthe
differenceinrisk.Basedonthisinformation,however,AssetYappearstobethebetterchoice.
d.
Usingthecapitalassetpricingmodel,therequiredreturnoneachassetisasfollows:
Capitalassetpricingmodel:rjRF[bj(rmRF)]
Asset
RF[bj(rmRF)]
rj
7%[1.6(10%7%)]
11.8%
7%[1.1(10%7%)]
10.3%
Fromthecalculationsinparta,theexpectedreturnforAssetXis11.74%,comparedtoitsrequired
returnof11.8%.Ontheotherhand,AssetYhasanexpectedreturnof11.14%andarequiredreturn
ofonly10.8%.ThismakesAssetYthebetterchoice.
e.
Inpartc,weconcludedthatitwouldbedifficulttomakeachoicebetweenXandYbecausethe
additionalreturnonXmayormaynotprovidetheneededcompensationfortheextrarisk.In
partd,bycalculatingarequiredrateofreturn,itwaseasytorejectXandselectY.Therequired
returnonAssetXis11.8%,butitsexpectedreturn(11.74%)islower;thereforeAssetXis
unattractive.ForAssetYthereverseistrue,anditisagoodinvestmentvehicle.
Clearly,ChargerProductsisbetteroffusingthestandarddeviationandcoefficientofvariation,rather
thanastrictlysubjectiveapproach,toassessinvestmentrisk.BetaandCAPM,however,providea
linkbetweenriskandreturn.Theyquantifyriskandconvertitintoarequiredreturnthatcanbe
comparedtotheexpectedreturntodrawadefinitiveconclusionaboutinvestmentacceptability.
Contrastingtheconclusionsintheresponsestopartscanddaboveshouldclearlydemonstratewhy
Juniorisbetteroffusingbetatoassessrisk.
f.
1. Increaseinriskfreerateto8%andmarketreturnto11%:
Asset
RF[bj (rmRF)]
X
Y
8%[1.6(11%8%)]
8%[1.1(11%8%)]
rj
12.8%
11.3%
2. Decreaseinmarketreturnto9%:
Asset
RF[bj (rmRF)]
rj
7%[1.6(9%7%)]
10.2%
7%[1.1(9%7%)]
9.2%
InSituation1,therequiredreturnrisesforbothassets,andneitherhasanexpectedreturnabovethe
firmsrequiredreturn.
WithSituation2,thedropinmarketratecausestherequiredreturntodecreasesothattheexpected
returnsofbothassetsareabovetherequiredreturn.However,AssetYprovidesalargerreturn
comparedtoitsrequiredreturn(11.149.201.94),anditdoessowithlessriskthanAssetX.
Spreadsheet Exercise
TheanswertoChapter8sstockportfolioanalysisspreadsheetproblemislocatedontheInstructors
ResourceCenteratwww.pearsonhighered.com/ircundertheInstructorsManual.
Group Exercise
Groupexercisesareavailableinwww.myfinancelab.com.
Thisexerciseusescurrentinformationfromseveralwebsitesregardingtherecentperformanceofeach
groupsshadowfirm.Thisinformationisthencomparedtoarelevantindex.Thetimeperiodsfor
comparisonare1and5years.Calculatedannualreturnsandbasicgraphicalanalysisbegintheprocess
ofcomparison.Correlationbetweenthefirmandthemarketisinvestigated.
Accurateandtimelyinformationisthefirstmessageofthisassignment.Studentsareencouragedtolook
atseveralsitesandalsotosearchforothers.Theinformationcontentofthedifferentsitescanthenbe
compared.Thisinformationisusedtogetstudentstoseehowbasicstockmarketanalysisisdone.
Asalways,partsofthisexercisecanbemodifiedordroppedattheadoptersdiscretion.Onesuggestion
istoaddothercorporationstothecomparison(s).Also,someofthemorecomplexcalculationscouldbe
eliminated.

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Part4

Integrative Case 4: Eco Plastics Company

Suggested Answer to Opener in Review Question

Answers to Review Questions

[(endingvalue initialvalue) cashdistribution]

Suggested Answer to Global Focus Box:

Suggested Answer to Focus on Ethics Box:

Answers to Warm-Up Exercises

Answer: CV10.100.150.6667 CV20.050.120.4167

($21,000 $20,000 $1,500)

($55,000 $55,000 $6,800)

Project 257 0.027350 0.165378

0.40 0.04 0.36

0.10 0.04 0.06

0.35 0.11 .24

0.40 0.10 .30

0.20 0.10 .10

0.10 0.10 0.00

17.6 16.4 16.0 15.2 14.0 13.6

(17.6% 15.5%)2 (16.4% 15.5%)2 (16.0% 15.5%)2

(15.2% 15.5%)2 (14.0% 15.5%)2 (13.6% 15.5%)2

(.000441 0.000081 0.000025 0.000009 0.000225 0.000361)

16% 17% 18% 19%

16.5% 16.5% 16.5% 16.5%

15.0% 16.0% 17.0% 18.0%

[(16.0% 17.5%)2 (17.0% 17.5%)2 (18.0% 17.5%)2 (19.0% 17.5%)2 ]

[(1.5%)2 (0.5%)2 (0.5%)2 (1.5%)2 ]

(0.000225 0.000025 0.000025 0.000225)

[(16.5% 16.5%)2 (16.5% 16.5%) 2 (16.5% 16.5%) 2 (16.5% 16.5%)2 ]

[(0)2 (0)2 (0)2 (0)2 ]

[(15.0% 16.5%)2 (16.0% 16.5%) 2 (17.0% 16.5%) 2 (18.0% 16.5%)2 ]

[(1.5%)2 (0.5%)2 (0.5%)2 (1.5%)2 ]

[(0.000225 0.000025 0.000025 0.000225)]

$2.22584 1,000shares $2,225.84

$2.51269 1,000shares $2,512.69

($20,000 $20,000) $1,600 $1,600

($36,000 $35,000) $1,400 $2,400

($34,500 $30,000) 0 $4,500

($16,500 $15,000) $375 $1,875

($107,000 $100,000) $3,375 $10,375

Analyzing Risk and Return on Chargers Products Investments

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