Problems 6.

Risk and return

1) Douglas Keel, a financial analyst for Orange Industries, wishes to estimate the rate of return for
two similar-risk investments, X and Y. Keel’s research indicates that the immediate past returns
will serve as reasonable estimates of future returns. A year earlier, investment X had a market
value of $20,000, investment Y of $55,000. During the year, investment X generated cash flow of
$1,500 and investment Y generated cash flow of $6,800. The current market values of investments
X and Y are $21,000 and $55,000, respectively.
a. Calculate the expected rate of return on investments X and Y using the most recent year’s data.
b. Assuming that the two investments are equally risky, which one should Keel recommend?
Why?
2) Return calculations for each of the investments shown in the following table, calculate the rate of
return earned over the unspecified time period.

3) Micro-Pub, Inc., is considering the purchase of one of two microfilm cameras, R and S. Both
should provide benefits over a 10-year period, and each requires an initial investment of $4,000.
Management has constructed the following table of estimates of rates of return and probabilities
for pessimistic, most likely, and optimistic results.

a. Determine the range for the rate of return for each of the two cameras.
b. Determine the expected value of return for each camera.
c. Purchase of which camera is riskier? Why?

4) Swift Manufacturing must choose between two asset purchases. The annual rate of return and the
related probabilities given in the following table summarize the firm’s analysis to this point.
 a. For each project, compute:
(1) The range of possible rates of return.
(2) The expected value of return.
(3) The standard deviation of the returns.
(4) The coefficient of variation of the returns.
b. Construct a bar chart of each distribution of rates of return.
c. Which project would you consider less risky? Why?

5) Jamie Wong is considering building a portfolio containing two assets, L and M. Asset L will
represent 40% of the dollar value of the portfolio, and asset M will account for the other 60%. The
expected returns over the next 6 years, 2004–2009, for each of these assets, are shown in the
following table.

a. Calculate the expected portfolio return, kp, for each of the 6 years.
b. Calculate the expected value of portfolio returns, kp, over the 6-year period.
c. Calculate the standard deviation of expected portfolio returns, kp , over the 6-year period.
d. How would you characterize the correlation of returns of the two assets L and M?
e. Discuss any benefits of diversification achieved through creation of the portfolio.