 Solutions to Problems

1. The investor would earn income of $2.25 and a capital gain of $52.50 – $45 =$7.50. The total gain is
$9.75 or 21.7%. $8.25 on a stock that paid $3.75 in income and sold for $67.50. Part of the total
dollar return includes a $4.50 capital gain, which is the difference between the proceeds of the sale
and the original purchase price ($67.50 – $63.00) of the stock.
3. a. Income:  $ 2.70
b. Capital gain: $60.00 – $50.00  $10.00
c. Total return:
(1) In dollars: $2.70  $10.00  $12.70
(2) As a percentage of the initial investment: $12.70  0.25 or 25%.
$50.00

5. a. Total return  Income  Capital gains (or losses) where:

Capital gains (or losses)  Ending price – Beginning price

(1) (2) (3) (4) (5)

(1) – (2) (3)  (4)
Ending Beginning  Capital  Current  Total
Year Price – Price  Gain  Income  Return
2010 $32.50 $30.00 $2.50 $1.00 $3.50
2011 35.00 32.50 2.50 1.20 3.70
2012 33.00 35.00 –2.00 1.30 –0.70
20130 40.00 33.00 7.00 1.60 8.60
20141 45.00 40.00 5.00 1.75 6.75

b. Of course, there is no correct answer here, but one might forecast using the arithmetic average or
the average one-year holding period return.
$3.50  $3.70  $.70  $8.60  $6.75
i. The arithmetic average:  $4.37
5
ii. The average holding period return (HPR):
Ending price  Beginning price  Current income Total return
HPR  
Beginning price Beginning price

(1) (2) (3)

Total Beginning (1)  (2)
Year Return* Price HPR
2010 $3.50 $30.00 11.7%
2011 3.70 32.50 11.4
2012 –0.70 35.00 –2.0
2013 8.60 33.00 26.1
2014 6.75 40.00 16.9
*From part a.

Smart/Gitman/Joehnk, Fundamentals of Investing, 12/e Chapter 4

 11.7  11.4  2.0  26.1  16.9
Average HPR   12.8%
5

i. ii.
Based on Based on
Forecasts for: Arithmetic Average Average HPR
2015 $4.37 ($45.00)*  0.128  $5.76
2016 $4.37 ($49.00)**  0.128  $6.27
End of 2010 price gain in original data
For lack of information, we are assuming the 2011 return is $4.00 from capital
gains and $1.76 from income.

c. Students should be made aware of the fact that many other forecasts are possible. Other factors
may be relevant here: Will the pattern of two good years followed by a bad one continue? Do
future prospects seem bright? (We will discuss forecasting returns on specific investments in
later chapters.)

7. a. Using the notation given in the chapter, the risk-free rate of return is:
Rf = r* + IP or 2% +3%
b. The required returns for each investment are calculated as follows:
r1  r * r *  IP  RPi or RF  RPi
rA  2%  3% % 5%  4%
 9%
rB  2% 3%  6% 5%  6%
 11%

Current income  Ending price  Beginning price

9. Holding period return (HPR) 
Beginning price

$1.00  $1.20  $0  $2.30  $29.00  $30.00 $3.50

HPR X  
$30.00 $30.00
 11.67%
$0  $0  $0  $2.00  $56.00  $50.00 $8.00
HPR Y  
50.00 $50.00
 16%
If the investments are held beyond a year, the capital gain (or loss) component would not be realized
and would likely change. Assuming they are of equal risk, Investment Y would be preferred since it
offers the higher return (16.00% for Y versus 11.67% for X).

11. HPR  ($50  ($1,000  $950))/$950  $100/$950  10.5%.

13. Using a present value interest factor of 4%:

Smart/Gitman/Joehnk, Fundamentals of Investing, 12/e Chapter 4

 $65  0.962  $62.53
$70  0.925  $64.75
$70  0.889  $62.23
$7,965  0.855  $6,810.08
$6,999.59
15.
Initial Future Calculator
Investment Investment Value Years Solution
A $1,000 $1,200 5 3.71%
B 10,000 20,000 7 10.41
C 400 2,000 20 8.38
D 3,000 4,000 6 4.91
E 5,500 25,000 30 5.18

17. The yield for these investments is the discount rate that results in the stream of income equaling the
initial investment.

The yield or internal rate of return for Investment A can easily be found with any financial calculator:

N=5, PV=-8500, PMT=2500, FV =0, i=14.40%

Most financial calculators can also solve for the internal rate of return of irregular cash flows, but the
routines vary widely from device to another. The yields or internal rates of return for either A or B
can be found quickly using Excel’s internal rate of return formula =irr(range of cells containing cash
flows). Be sure to include the initial investment as a negative cash flow.
End of Year Investment A Investment B
0 (8,500.00) (9,500.00)
1 2,500.00 2,000.00
2 2,500.00 2,500.00
3 2,500.00 3,000.00
4 2,500.00 3,500.00
5 2,500.00 4,000.00
IRR 14.40% 15.36%

Smart/Gitman/Joehnk, Fundamentals of Investing, 12/e Chapter 4

19. Again this problem is most easily solved using Excel’s internal rate of return formula =irr(range of
cash flows). The yield on this investment falls just short of the required 11%, and the NPV when
discounted at 11% (=npv(.11,range of positive cash flows)-1000) is slightly negative, so the
investment probably should not be accepted.

End of Year Income Stream

$ (1,000)
2014 140
2015 120
2016 100
2017 80
2018 60
2019 40
2020 1,220
IRR/Yield 10.87%
NPV @ 11% –604.56%

21. 2013 – 2006  7 years

Using a financial calculator,
N=7, PV=-1.00, PMT=0,
FV=2.21, i=12.00% ans
Excel =rate(7,0,1.00,2.21)

23. a. Investment A, with returns that vary widely—from 1% to 26%—appears to be more risky than
Investment B, whose returns vary from 8% to 16%.
n
b. s   (r  r )2
i 1

Standard deviation
CV 
Average return
Investment A:

(1) (2) (3) (4)

Return Average (1) – (2) (3)2
Year rI Return, r ri – r (ri – r)2
2006 19% 12% 7% 49%
2007 1 12 –11 121
2008 10 12 –2 4
2009 26 12 14 196
2010 4 12 –8 64
434

Smart/Gitman/Joehnk, Fundamentals of Investing, 12/e Chapter 4

 434
SA   108.5  10.42%
 
10.42%
CV   .87
12.00%

Investment B:

(1) (2) (3) (4)

Year Return Average (1) – (2) (3)2
ri Return, r ri – r (ri – r)2
2006 8% 12% –4% 16%
2007 10 12 –2 4
2008 12 12 0 0
2009 14 12 2 4
2010 16 12 4 16
40

40
SA   10  3.16%
 
3.16%
CV   .26
12.00%

c. Investment A, with a standard deviation of 10.42, is considerably more risky than Investment B,
whose standard deviation is 3.16. This confirms the conclusions reached in Part A.

Smart/Gitman/Joehnk, Fundamentals of Investing, 12/e Chapter 4