University of Technology, Jamaica

FINANCIAL MANAGEMENT: FIN3001

UNIT 3: Risk and Rates of Return

TUTORIAL QUESTIONS

1. If a company's beta were to double, would its returns double?

2. Suppose you owned a portfolio consisting of US$250,000 worth of long-term US

government bonds.

(i) Would your portfolio be riskless?

(ii) Suppose you hold a portfolio of $250,000 worth of 30-day Treasury bills. Every
30 days your bills mature, and you reinvest the principal in a new batch of bills.
Assume you live on the investment income from your portfolio and that you want
to maintain a constant standard of living. Is your portfolio truly riskless?
(iii) Can you think of any asset that would be completely riskless? Explain.

3. PCB Corporation is a holding company with four main subsidiaries. The percentage of its
business coming from each of the subsidiaries, and their respective betas are as follows:

Subsidiary Percentage of Capital Beta

Manufacturing 40% 0.8
Agro-industry 28% 0.9
Finance 21% 1.3
Retail 11% 1.5

(i) What is the holding company's beta?

(ii) Assume that the risk-free rate is 4.5% and the market risk premium is 6.5%. What is
the holding company's required rate of return?
(iii) PCB is considering a change in its strategic focus. It will reduce its reliance on the
Agro-industry, so the percentage of its business from this subsidiary will be 13%. At
the same time, it will increase its reliance on the Retail, so the percentage of its
business from that division will rise to 26%. What will be the shareholders' required
rate of return if they make these changes?

4. Jane Katy, a mutual fund manager, has a $18 million portfolio with a beta of 1.2. The
risk-free rate is 4.5% and the market risk premium is 5.5%.
(i) What is the required rate of return for this portfolio?
(ii) Jane expects to receive an additional $7 million, which she plans to invest in several
stocks. After investing the additional funds, she wants the fund’s required return to
be 12.2%. Given the new required return what is the average beta of the new
portfolio?
(iii) What is the average beta of the $7 million-dollar investment?
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5. An individual has $27,000 invested in a stock that has a beta of 0.8 and $38,000 invested
in a stock with a beta of 1.4. If these are the only investments in her portfolio, what is her
portfolio's beta?

6. Assume that the risk-free rate is 4.8% and the expected return on the market is 12.4%.
What is the required rate of return on a stock that has a beta of 1.15?

7. Assume the risk-free rate is 4.25% and the market premium is 6.5%, What is the expected
return for the overall stock market? What is the required rate of return on a stock that has
a beta of 0.78?

8. Stocks A and B have the following historical returns:

Year Stock A’s Returns, rA Stock B’s Returns, rB

(%) (%)
2016 (16.0) 12.2
2017 33.5 22.3
2018 15.8 32.2
2019 (0.8) (9.2)
2020 26.0 25.4

(i) Calculate the average return for each stock during the period 2016 to 2020.
(ii) Assume that someone held a portfolio consisting of 50% A and 50% B. What would
have been their realized rate of return on the portfolio in each year from 2016 to
2020? What would have been the average return on the portfolio during this period?
(iii) Calculate the standard deviation of returns for each stock and for the portfolio.
(iv) Calculate the coefficient of variation for each stock and for the portfolio.
(v) Assuming you are a risk-averse investor, would you prefer to hold Stock A, Stock B,
or the portfolio? Why?

9. Stocks X and Y have the following probability distributions of expected future returns

PROBABILITY X% Y%
0.10 (10) (35)
0.25 2 0
0.35 12 20
0.25 20 25
0.05 38 45

(i) Calculate the expected rate of return, k, for stock Y (kX = 10.6%)
(ii) Calculate the standard deviation of expected return for stock X. (That for Y is
19.39%)
(iii) Calculate the coefficient of variation for stocks X and Y.
(iv) As a risk averse investor, which stock would you prefer?

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10. Stock X has a 10.5% expected return, a beta coefficient of 0.75, and a 30% standard
deviation of expected returns. Stock Y has a 12.5% expected return, a beta coefficient of
1.4 and a 26% standard deviation. The risk-free rate is 4.5% and the market risk
premium is 6%.
(i) Calculate each stock’s coefficient of variation.
(ii) Which stock is riskier for a diversified investor?
(iii) Calculate each stock’s required rate of return.
(iv) Based on the two stocks expected and required rates of return which stock would
be more attractive to a diversified investor?
(v) Calculate the required rate of return of a portfolio has $6,200 invested in Stock X
and $3,800 invested in Stock Y.
(vi) If the market risk premium increased to 8%, which of the two stocks would have
the larger increase in its required return?
(vii) If the risk-free rate increased to 6%, which of the two stocks would have the
larger increase in its required return?

11. Suppose you hold a diversified portfolio consisting of $5,000 investment in each of 10
different common stocks. The portfolio beta is 1.55. Now, suppose you decide to sell one
of the stocks in your portfolio with a beta equal to 0.9 for $5,000 and to use these
proceeds to buy another stock for your portfolio. Assume the new stock's beta is 1.87.
Calculate the new portfolio's beta.

12. Suppose you are the money manager of a $2.5 million investment fund. The fund consists
of 4 stocks with the following investments and betas:

STOCK INVESTMENT BETA

A $ 250,000 1.50
B $ 350,000 -0.50
C $. 650,000 1.25
D $1,250,000 0.75

If the market required rate of return is 12.3% and the risk-free rate is 3.8%, what is the
fund's required rate of return?

13. You have been managing a $3.6 million portfolio which has a beta of 1.25 and a required
rate of return of 14.5%. The current risk-free rate is 4.25%. Assume that you receive
another $400,000. If you invest this money in a stock with beta 0.75, what will be the
required rate of return on your $4 million portfolio?

14. Bradford Manufacturing Company has a beta of 1.25, while Farley Industries has a beta
of 0.95. The required return on an index fund that holds the entire stock market is 13.5%.
The risk-free rate of interest is 5.3%. By how much does Bradford’s required return
exceed Farley’s required return?
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