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Solution Manual For Principles of Managerial Finance Brief 8th Edition Zutter
Solution Manual For Principles of Managerial Finance Brief 8th Edition Zutter
Solution Manual For Principles of Managerial Finance Brief 8th Edition Zutter
Part 4
Risk and the Required Rate of Return
Instructor’s Resources
Chapter Overview
This chapter focuses on the fundamentals of risk and return—beginning with simple definitions of total and
expected return, risk neutral, risk averse, and risk seeking. The discussion then moves to risk measurement by
focusing on a single asset and measuring risk with statistics associated with a probability distribution—
namely, mean, standard deviation, and coefficient of variation. To demonstrate that insights about risk for a
single asset do not necessarily carry through to a collection of assets, the discussion broadens to risk and
return for a portfolio. Diversification is introduced through examination of risk for a portfolio of positively
correlated, negatively correlated, and uncorrelated assets. The key takeaway is that the volatility (risk) of a
portfolio will be less than a weighted average of the volatilities of the assets in the portfolio as long as the
correlation is less than 1.0. The potential for risk-reduction through international diversification is offered as an
intuitive example. These ideas are used to motivate the Capital Asset Pricing Model (CAPM). Diversifiable
and nondiversifiable risk are distinguished, with the key idea that the market only rewards bearing
nondiversifiable risk because firm-specific risk can so easily be eliminated through diversification. Then, the
CAPM equation and its pictorial representation (Security Market Line or SML) are introduced to show the
link between return and nondiversifiable risk. The chapter concludes by illustrating the impact of changes in
inflation expectations and investor risk aversion on the SML.
8-2 Total return (gain or loss) on an investment over a given time period is the change in value over that
period plus any cash distributions, expressed as a percentage of beginning-of- period value.
Specifically:
[(ending value − initial value) + cash distribution]
Return =
initial value
8-3 a. Risk-averse investors dislike risk and, therefore, expect higher returns on riskier investments.
b. Risk-neutral investors select investments based on expected return—the higher the better—without
regard to risk. Such investors require no compensation for bearing more risk.
c. Risk-seekers like risk. Just as risk-averse investors will give up some return to avoid some risk,
risk-seeking investors will give up some return to take more risk.
Most financial managers are risk averse—they expect compensation for bearing additional risk. Risk
tolerance refers an investor’s degree of risk aversion, that is the specific compensation she requires for
taking additional risk. Two investors may both refuse to accept more risk unless awarded a higher
expected return—that is, both are risk averse. But the more risk tolerant of the two will require less
additional compensation.
8-4. Scenario analysis assesses asset risk using more than one possible set of returns to gauge the variability
of outcomes. Range—a measure of variability—is found by subtracting the pessimistic outcome from
the optimistic outcome, with larger ranges suggesting greater risk. Note, however, after getting deeper
into the chapter, students will learn the range of outcomes suffers as a risk measure by not
distinguishing diversifiable and undiversifiable components.
8-5 Decision makers can estimate risk with a plot of the probability distribution—which relates probabilities
to potential returns by showing the dispersion in returns. The wider the distribution of potential returns,
the greater the variability (risk) associated with returns. It is important to note, however, the plot offers
a feel for an asset’s risk but does not distinguish between diversifiable and undiversifiable components.
8-6. The standard deviation of a distribution of asset returns is an absolute measure of dispersion of risk
around the mean or expected value. A higher standard deviation more variable returns.
8-7 The coefficient of variation (CV)—another risk indicator—is the standard deviation on an asset’s
returns divided by its average return. In other words, rather than measuring risk solely by the volatility
of an asset’s returns, CV shows the volatility of returns relative to average or expected return.
8-8 An efficient portfolio offers the maximum return for a given risk level. Portfolio return is just the
weighted average of returns on individual assets in the portfolio. Specifically:
rσp = (w1 × r1) + (w2 × r2) + … + (wn × rn) = ∑𝑤 × 𝑟
where:
rσp = portfolio return rj = the return on asset j
wj = the portfolio weight of asset j (∑ 𝑤 = 1) n = number of assets in the portfolio
The standard deviation of a portfolio is not the weighted average of the standard deviations of
component assets. Rather, it is calculated with the standard-deviation formula, using portfolio returns
for various time periods (rather than returns on individual assets in the portfolio) and the average
portfolio return over those time periods. Specifically:
̅
σrp = ∑ ()
where: σrp = standard deviation of portfolio returns
8-9 The correlation between asset returns is key to evaluating the effect of a new asset on portfolio risk.
Returns on different assets that move in the same direction are positively correlated, while those
moving in opposite directions are negatively correlated. Unless the returns on assets in a portfolio are
perfectly positively correlated, portfolio standard deviation will be less than the weighted average of
the standard deviations of portfolio assets. If the absolute value of correlation between assets in the
portfolio is sufficiently low—it need not be negative—portfolio standard deviation may be less than the
standard deviation of the least volatile portfolio asset. In short, the magic of diversification is that
portfolio returns can be less volatile than the returns on any single portfolio asset.
8-10 Adding foreign assets to a domestic portfolio can reduce risk for the same reason a portfolio of two
domestic assets can have less risk than one asset: returns on foreign investments are not perfectly
correlated with returns on U.S. investments, so an internationally diversified portfolio generally has a
lower standard deviation of returns (less risk) than a purely domestic portfolio. That said, under some
circumstances, international diversification can produce subpar returns. For example, when the dollar
appreciates relative to other currencies, the dollar value of foreign-currency-denominated portfolios
declines, thereby producing lower dollar returns. If the appreciation is traceable to a strong U.S.
economy, foreign-currency-denominated portfolios will generally have lower returns in local currency
as well, further reducing returns. Political risk—the risk political instability or hostile governments
could endanger foreign assets or profits—is another potential pitfall of international diversification,
particularly when investing in developing countries.
8-11 The total risk of a security is measured by the standard deviation of returns; it has two components –
nondiversifiable risk and diversifiable risk. Diversifiable risk refers to the portion of risk attributable to
firm-specific, random events (such as strikes, litigation, and loss of key contracts) that can be
eliminated by diversification. Nondiversifiable risk, in contrast, is attributable to market factors
affecting all firms at the same time (such as war, inflation, and political events). Nondiversifiable risk
is the only relevant risk because diversifiable risk can be easily eliminated by forming a portfolio of
assets with less than perfect positive correlation. Because investors can easily eliminate this risk, the
market will not offer compensation in the form of higher returns to those who bear it.
8-12 Beta measures the nondiversifiable risk of a specific asset or portfolio; it is an index of the co-
movement of an asset’s return with the market return. The beta coefficient for an asset can be found by
plotting the asset’s historical returns relative to the returns for the market and using statistical
techniques to fit the “characteristic line” to the data points. The slope of this line is beta. Beta
coefficients for actively traded stocks are widely published in print and online. The beta of a portfolio
is simply the weighted average of the betas of component assets.
8-14 a. An increase in inflationary expectations shifts the SML upwards by an amount equal to the
increase. The shift is parallel—that is, SML slope remains the same—because the only change is
that required return for a given level of risk rose to reflect the higher expected inflation rate.
b. If investors become less risk averse, the slope of the SML (beta coefficient) will decline—that is
the SML will rotate clockwise around the given fixed risk-free rate because a lower return is now
required for each level of risk.
Global funds differ from international funds by investing in stocks and bonds around the world, including
U.S. securities. International funds, in contrast, invest in stocks and bonds around the world but not U.S
securities. Global funds, therefore, are more likely to be correlated with U.S. mutual funds because U.S.
securities (particularly equities) are typically a sizeable chunk of their portfolios. A U.S. investor seeking to
further internationally diversify her portfolio should either add international funds or—if the portfolio already
includes global funds—increase the portfolio weight of those funds.
Investment 1 has a standard deviation of 10% and an average return of 15% while Investment 2
has a standard deviation of 5% and an average return of 12%, so:
CV1 = 0.10 ÷ 0.15 = 0.6667 CV2 = 0.05 ÷ 0.12 = 0.4167
Based on standard deviations and coefficients of variation, Investment 2 has lower risk if held in
isolation. That said, neither standard deviation nor coefficient of variation decomposes measured
volatility into nondiversifiable and diversifiable components. But coefficient of variation does at
least measure an asset’s volatility relative to expected return and, therefore, offers a broader
perspective on risk than standard deviation alone.
E8-5 Ca
alculating a portfolio
p beta
a (LG 5)
Answer: Portfolio beta
b is just thee weighted av verage of betaas of individual portfolio coomponents, mmeaning
the beta on
n each asset iss weighted by
y its share of tthe portfolio aand weightedd betas summeed.
Specificallly:
Beta = (0.2
20 × 1.15) + (0.10
( × 0.85) + (0.15 × 1.660) + (0.20 × 1.35) + (0.35 × 1.85)
= 0.2300 + 0.0850 + 0.2
2400 + 0.2700
0 + 0.6475 = 1.4725
E8-6 Ca
alculating thee required ratte of return (LG 6)
Answer: The CAPMM equation caan be used to find required return, givenn an asset’s beeta, the risk-fr
free rate,
and markeet return. Speccifically:
rj = RF + ⎡⎣ β j × ( rm − RF ) ⎤⎦
where:
rj = required
r returrn on asset j j=BBeta coefficiennt for asset j
RF = risk-free ratee rm = Exxpected returrn on market pportfolio of assets
a. Requirred return = 0.05
0 + 1.8 (0.1
10 − 0.05) = 00.05 + 0.09 = 0.14.
b. Requirred return = 0.05
0 + 1.8 (0.1
13 − 0.05) = 00.05 + 0.144 = 0.194.
c. The rissk-free rate does not changge, but markeet return increeases. The resulting rise in the
markett-risk premium m will cause the Security MMarket Line (SML) to rotaate countercloockwise
about the
t fixed risk k-free rate..
Solutions to Prroblems
P8-1 Rate
R of return
n (LG 1; Bassic)
Total returrn on an invesstment is giveen by:
(Pt − Pt −1 + Ct )
rt =
Pt−1
where: rt = total reeturn on assett Pt = Price of assset at time t-1
Pt = Price of
o asset at tim
me t Ct = Cash receivved between tt-1 and t
d. The answer is no longer clear because it now involves a risk-return tradeoff. Project B now offers
a slightly higher average return but more risk, while A has both lower return and lower risk.
Camera Range
R 30% − 20% = 10%
S 35% − 15% = 20%
c. Line K appears less risky because of a slightly tighter distribution of potential outcomes.
P8-8 Standard deviation versus coefficient of variation as measures of risk (LG 2; Basic)
a. Project A is least risky based on range because it has the smallest value (4%).
b. Project A has the lowest standard deviation. Standard deviation fails to take into account both the
volatility and return of the investment and does not distinguish between a project’s diversifiable
and nondiversifiable risk.
σr
c. Coefficient of variation is given by : CV = ,
r
where 𝜎 is the standard deviation of returns and 𝑟̅ is expected return. The coefficients of
variation for projects A, B, C, and D are:
0.029 0.035
A: CVA = = 0.2417 C: CVC = = 0.2692
0.12 0.13
0.032 0.030
B: CVB = = 0.2560 D: CVD = = 0.2344
0.125 0.128
Project D may be the best alternative because it has the least amount of risk per percentage point
of return. Coefficient of variation is probably the best measure here because it provides a
standardized method of capturing the risk-return tradeoff for investments with differing returns.
That said, like the standard deviation, the coefficient of variation does not distinguish between an
investment’s diversifiable and nondiversifiable risk.
P8-9 Personal finance: Rate of return, standard deviation, coefficient of variation (LG 2; Challenge)
a.
Stock Price
Year Beginning End Returns
2015 $14.36 $21.55 50.07%
2016 21.55 64.78 200.60%
2017 64.78 72.38 11.73%
2018 72.38 91.80 26.83%
Average return = 72.31%
n
∑(r −r )
2
j
j =1
b. Standard deviation is given by: σ = ,
n −1
where rj is return in year j (running to year n) and 𝑟̅ is average return over n years. In this
problem:
Average Difference
Year Returns Return Difference Squared
2015 50.07% 72.31% -22.24% 0.04945064
2016 200.60% 72.31% 128.29% 1.64589656
2017 11.73% 72.31% -60.58% 0.36696335
2018 26.83% 72.31% -45.48% 0.20682030
Sum of Squared Differences = 2.26913085
n-1 = 3
Sum of Squared Differences / ( n-1) = 0.75637695
√[Sum of Squared Differences / ( n-1)] = σ = 0.86969934
86.97%
c. Coefficient of variation is given by CV = 𝜎 ÷ 𝑟̅ where 𝜎 is standard deviation of returns and 𝑟̅ is
expected return: 86.97% ÷ 72.31% = 1.2.
d. Stock price of Hi-Tech, Inc. fluctuated wildly over the four-year period and would have to be
classified as a volatile security (albeit with an upward price trend). Note how coefficient of
variation provides additional perspective—for each unit of return, the stock carries 1.2 units of
volatility. Hi-Tech stock exceeds Mike’s risk limit of a coefficient of variation of returns of 0.9.
But, depending on this personal risk-return tradeoff, Mike could make an exception and add the
Hi-Tech stock to his portfolio if he believes the recent large returns will continue.
ri is the return for outcome i, r is the average return across all outcomes, and Pri is the
probability of outcome i.
(4) Coefficient of variation (CV) is given by σ ÷ r , where σ is the standard deviation of returns
on the asset and r is the average return. So:
0.165378
CV = = 0.3675
0.450
Project 432
(1) Range: 0.50 − 0.10 = 0.40 percentage points
(2) Expected or average return:
n
r = ∑ ri × Pri where ri = return for outcome i, and Pri is probability of outcome i:
i=1
n
(3) Standard deviation: σ = ∑ (r − r )
i =1
i
2
× Pri , where:
ri is the return for outcome i, r is the average return across all outcomes, and Pri is the
probability of outcome i.
(4) Coefficient of variation (CV) is given by σ ÷ r , where σ is the standard deviation of returns
on the asset and r is the average return. So: CV = 0.106066 ÷ 0.300 = 0.3536.
b. Bar charts
c. Summary statistics
Project 257 Project 432
Range 1.100 0.400
Expected return (r ) 0.450 0.300
Standard deviation (σ r ) 0.165 0.106
Coefficient of variation (CV) 0.368 0.354
Project 432 has a lower range, standard deviation, and coefficient of variation, so it appears the
less risky option (though, again, the given information does not allow decomposition of return
volatility into diversifiable and nondiversifiable components).
n
b. Standard deviation: σ = ∑ (r − r )
i =1
i
2
× Pri , , where ri is the return for outcome i, r is the
average return across all outcomes, and Pri is the probability of outcome i.
Asset F
Column → (1) (2) (3) (4) (5) (6)
Return Average Probability
2
(r i ) Return (r) = (1) ─ (2) = (3) (P ri ) = (4) x (5)
0.40 0.04 0.360 0.1296 0.100 0.012960
0.10 0.04 0.060 0.0036 0.200 0.000720
0.00 0.04 -0.040 0.0016 0.400 0.000640
-0.05 0.04 -0.090 0.0081 0.200 0.001620
-0.10 0.04 -0.140 0.0196 0.100 0.001960
Sum = 0.017900
√ (Sum) = Standard Deviation (σ) = 0.133791
= 13.38%
Asset F
Column → (1) (2) (3) (4) (5) (6)
Return Average Probability
2
(r i ) Return (r) = (1) ─ (2) = (3) (P ri ) = (4) x (5)
0.40 0.04 0.360 0.1296 0.100 0.012960
0.10 0.04 0.060 0.0036 0.200 0.000720
0.00 0.04 -0.040 0.0016 0.400 0.000640
-0.05 0.04 -0.090 0.0081 0.200 0.001620
-0.10 0.04 -0.140 0.0196 0.100 0.001960
Sum = 0.017900
√ (Sum) = Standard Deviation (σ) = 0.133791
= 13.38%
Asset G
Column → (1) (2) (3) (4) (5) (6)
Return Average Probability
2
(r i ) Return (r) = (1) ─ (2) = (3) (P ri ) = (4) x (5)
0.35 0.11 0.240 0.0576 0.400 0.023040
0.10 0.11 -0.010 0.0001 0.300 0.000030
-0.20 0.11 -0.310 0.0961 0.300 0.028830
Sum = 0.051900
√ (Sum) = Standard Deviation (σ) = 0.227816
= 22.78%
Asset H
Column → (1) (2) (3) (4) (5) (6)
Return Average Probability
2
(r i ) Return (r) = (1) ─ (2) = (3) (P ri ) = (4) x (5)
0.40 0.10 0.300 0.0900 0.100 0.009000
0.20 0.10 0.100 0.0100 0.200 0.002000
0.10 0.10 0.000 0.0000 0.400 0.000000
0.00 0.10 -0.100 0.0100 0.200 0.002000
-0.20 0.10 -0.300 0.0900 0.100 0.009000
Sum = 0.022000
√ (Sum) = Standard Deviation (σ) = 0.148324
= 14.83%
Based on standard deviation, Asset G appears to have the greatest risk.
c.
P8-13 Personal finance: Portfolio return and standard deviation (LG 3; Challenge)
a. Actual portfolio return for each year: rp = (wL × rL) + (wM × rM), where w is the portfolio weight of
asset L or M, and r is the actual return in a given year on asset L or M.
Year Asset L (wL × rL) + Asset M (wM × rM) Portfolio Return (rp)
2013 (14% × 0.40 = 5.6%) + (20% × 0.60 = 12.0%) = 17.6%
2014 (14% × 0.40 = 5.6%) + (18% × 0.60 = 10.8%) = 16.4%
2015 (16% × 0.40 = 6.4%) + (16% × 0.60 = 9.6%) = 16.0%
2016 (17% × 0.40 = 6.8%) + (14% × 0.60 = 8.4%) = 15.2%
2017 (17% × 0.40 = 6.8%) + (12% × 0.60 = 7.2%) = 14.0%
2018 (19% × 0.40 = 7.6%) + (10% × 0.60 = 6.0%) = 13.6%
b. Average return, Asset L (rL): (14% + 14% + 16% + 17% + 17% + 19%) ÷ 6 = 0.16167 = 16.2%
Average return, Asset M (rM): (20% + 18% + 16% + 14% + 12% + 10%) ÷ 6 = 0.15000 =15.0%
Portfolio return (rp): (17.6% + 16.4% + 16.0% + 15.2% + 14.0% + 13.6%) ÷ 6 = 0.15467 = 15.5%
(ri − r ) 2 n
c. Standard deviation for Asset L and Asset M: σ rp = ∑ ,
i =1 ( n − 1)
where ri is the asset return in year i (running to year n), and r is average return over n years:
Asset L
Column → (1) (2) (3)
Return Average
2
Year (r i ) Return (r) = (1) ─ (2) = (3)
2013 0.14000 0.16167 -0.022 0.000469
2014 0.14000 0.16167 -0.022 0.000469
2015 0.16000 0.16167 -0.002 0.000003
2016 0.17000 0.16167 0.008 0.000069
2017 0.17000 0.16167 0.008 0.000069
2018 0.19000 0.16167 0.028 0.000803
Sum of Squared Differences = 0.001883
n─1= 5
Sum of Squared Differences / (n ─ 1) = 0.000377
√ [Sum of Squarted Differences) / (n ─ 1)] = σ = 0.019408
= 1.94%
Asset M
Column → (1) (2) (3)
Return Average
2
Year (r i ) Return (r) = (1) ─ (2) = (3)
2013 0.20000 0.15000 0.050 0.002500
2014 0.18000 0.15000 0.030 0.000900
2015 0.16000 0.15000 0.010 0.000100
2016 0.14000 0.15000 -0.010 0.000100
2017 0.12000 0.15000 -0.030 0.000900
2018 0.10000 0.15000 -0.050 0.002500
Sum of Squared Differences = 0.007000
n─1= 5
Sum of Squared Differences / (n ─ 1) = 0.001400
√ [Sum of Squarted Differences) / (n ─ 1)] = σ = 0.037417
= 3.74%
Portfolio
Column → (1) (2) (3)
Return Average
2
Year (r i ) Return (r) = (1) ─ (2) = (3)
2013 17.6% 0.15 0.021 0.000455
2014 16.4% 0.15 0.009 0.000087
2015 16.0% 0.15 0.005 0.000028
2016 15.2% 0.15 -0.003 0.000007
2017 14.0% 0.15 -0.015 0.000215
2018 13.6% 0.15 -0.019 0.000348
Sum of Squared Differences = 0.001141
n─1= 5
Sum of Squared Differences / (n ─ 1) = 0.000228
√ [Sum of Squarted Differences) / (n ─ 1)] = σ = 0.015108
= 1.51%
d and e.
The standard deviation (risk) of portfolio returns is 1.51%, lower than either asset (1.94% for
Asset L and 3.74% for Asset M). So holding the two assets as a portfolio yields a diversification
benefit, indicating the returns on Asset L and M must be less than perfectly positively correlated.
[Note: The actual correlation coefficient between the returns on Asset L and Asset M is
-0.9635—the assets are highly negatively correlated—but negative correlation is not necessary
for a diversification benefit.]
where ri is asset return in year i (running to year n), and r is average return over n years:
Alternative 1:
100% Asset F
Column → (1) (2) (3)
Return Average
2
Year (r i ) Return (r) = (1) ─ (2) = (3)
2016 16% 0.175 -0.015 0.000225
2017 17% 0.175 -0.005 0.000025
2018 18% 0.175 0.005 0.000025
2019 19% 0.175 0.015 0.000225
Sum of Squared Differences = 0.000500
n─1= 3
Sum of Squared Differences / (n ─ 1) = 0.000167
√ [Sum of Squarted Differences) / (n ─ 1)] = σ = 0.012910
= 1.291%
Alternative 2:
50% Asset F and 50% Asset G
Column → (1) (2) (3)
Return Average
2
Year (r i ) Return (r) = (1) ─ (2) = (3)
2016 0.16500 0.16500 0.000 0.000000
2017 0.16500 0.16500 0.000 0.000000
2018 0.16500 0.16500 0.000 0.000000
2019 0.16500 0.16500 0.000 0.000000
Sum of Squared Differences = 0.000000
n─1= 3
Sum of Squared Differences / (n ─ 1) = 0.000000
√ [Sum of Squarted Differences) / (n ─ 1)] = σ = 0.000000
= 0.00%
Alternative 3:
50% Asset F and 50% Asset H
Column → (1) (2) (3)
Return Average
2
Year (r i ) Return (r) = (1) ─ (2) = (3)
2016 0.15000 0.16500 -0.015 0.000225
2017 0.16000 0.16500 -0.005 0.000025
2018 0.17000 0.16500 0.005 0.000025
2019 0.18000 0.16500 0.015 0.000225
Sum of Squared Differences = 0.000500
n─1= 3
Sum of Squared Differences / (n ─ 1) = 0.000167
√ [Sum of Squarted Differences) / (n ─ 1)] = σ = 0.012910
= 1.291%
c. Coefficient of variation (CV): σ r ÷ r , where σr is standard deviation of the investment alternative
and r is the average return of the investment alternative:
1.291% 0 1.291%
CVF = = 0.0738 CVFG = =0 CVFH = = 0.0782
17.5% 16.5% 16.5%
d. Summary:
r σr CV
Alternative 1 (F) 17.5% 1.291% 0.0738
Alternative 2 (FG) 16.5% 0 0.0
Alternative 3 (FH) 16.5% 1.291% 0.0782
Alternative 1 posted the highest return but Alternative 2 the lowest volatility (risk). When
thinking about performance, it is instructive to ask how a hypothetical investor might view these
alternatives. She would first note Alternative 2 is clearly preferable to Alternative 3 because it
offers the same expected return but no volatility in returns. Now, as between Alternatives 1 and 2,
Alternative 1 offers a higher expected return but also has more volatile returns. Without knowing
an investor’s risk tolerance, it is not possible to say whether Alternative 1 or 2 is “best.”
c. Only nondiversifiable risk is relevant because, as shown above, building a portfolio of at least 20
securities with imperfectly correlated returns substantially reduces diversifiable risk. When
additional securities no longer reduce risk, the remaining standard deviation of David Talbot’s
portfolio is non-diversifiable. That standard deviation of returns of 6.47% (down from 14.50%).
30.0%
Asset B
Beta = 1.38
25.0%
20.0%
15.0%
Asset A
Beta = 0.793
10.0%
5.0%
0.0%
-13.0% -8.0% -4.0% 0.0% 2.0% 6.0% 8.0% 10.0% 13.0% 15.0% 16.0%
-5.0% Market
Return
-10.0%
-15.0%
b. The betas for assets A and B are the slopes of the characteristic lines above. Typically, the slopes
of these lines are estimated with a statistical technique known as linear regression. But, slope can
also be calculated given any two points on a line. Here, we can obtain slopes (i.e., betas) with the
highest and lowest returns for each asset. Specifically:
Beta = ∆ Asset Return ÷ ∆ Market Return
BetaAsset A = Highest Return on Asset A – Lowest Return on Asset A
Highest Market Return – Lowest Market Return
= [0.19 – (–0.04)] ÷ [0.16 – (–0.13)] = 0.23 ÷ 0.29 = 0.793
c. Asset B should be chosen because it will have the highest increase in return.
d. Asset C would be the appropriate choice because it is a defensive asset, moving in opposition to
the market. In an economic downturn, Asset C’s return is increasing.
P8-25 Personal
P finan
nce: Beta coef
efficients and
d the CAPM ((LG 5 and LG
G 6; Intermeediate)
The
T CAPM eq quation is rj = RF + [βj × (rm − RF)], wherre rj is the exppected or requuired return oon asset j,
βj is the beta cooefficient for asset j, RF is the risk-free rate, and rm is the expectedd return on thhe market
ortfolio. The problem prov
po vides values for
f rj, RF and rm and asks foor beta; usingg the CAPM eequation:
(i) rj = RF + [βj × (rm − RF)] (iii) βj = (rj − RF) (rrm − RF)]
(ii) rj − RF = βj × (rm − RF)
0% − 5% 5%
10 5 18% − 5%
% 13%
a.. Beta = = = 0.45455 c. Betaa = = = 1.1818
6% − 5% 11%
16 16% − 5%
% 11%
5% − 5% 10%
15 20% − 5%
% 15%
b. Beta = = = 0.9091 d. Betaa = = = 1.3636
6% − 5% 11%
16 16% − 5%
% 11%
e.. If Katherin
ne is willing to
t take no more than the avverage amounnt of risk, her upper limit oon a beta
is 1.0. Giv 1 her expeccted return is 16% [r = 5% + 1.0(16% − 5%) = 16%.]].
ven a beta of 1.0,
P8-26 Manipulating
M CAPM (LG 6; Intermediiate)
Using
U the CAP PM equation: rj = RF + [ × (rm − RF)], where rj is thhe required return on asset jj,
RF the risk-freee rate, the beta on asset j,
j and rm the return on the market portffolio:
a.. Solve for rj if RF is 8%, nd rm is 12%: 8% + [0.90 × (12% − 8%))] =11.6%.
is 0.90, an
b. Solve for RF if rj is 15%
%, is 1.25, and
a rm is 14%
%:
15% = RF + [1.25 × (14 4% − RF)] → RF = 10%..
c.. Solve for rm if RF is 9%
%, if rj is 16%, and is 1.1 0:
16% = 9%% + [1.10 × (rm − 9%)] → rm = 15.36% %.
d. Solve for if rj is 15%
%, RF is 10%, and
a rm is 12.55%:
15% = 10%% + [ × (12 2.5% − 10%)] → = 2. 0
P8-27 Personal
P finan o return and beta (LG 1, L
nce: Portfolio LG 2, LG 3, LG 5, and L
LG 6: Challen
nge)
a.. The beta of
o a portfolio assets
a is the weighted
w averrage of the beetas of the inddividual assetss in the
portfolio, with
w the weig ght on each assset being thatt asset’s sharee in the portfoolio. Specifically,
= and =1→ =( )+( )+( )+( )
14.0% Asset A
Required Return = 12.2% Asset B
12.0% Market Risk Premium
1.3 (0.13 0.09) = 5.2%
10.0%
4.0%
Average Risk Asset
2.0% β=1
Market Risk Premium = 0.13 - 0.09 = 4%
0.0%
0 0.2 0.4 0.6 0.8 1.0 1.2 1.4 1.6 1.8 2.0
Beta
c. Using the CAPM equation: rj = RF + [𝛽 × (rm − RF)], where rj is the required return on asset j,
RF the risk-free rate, 𝛽 the beta on asset j, and rm the return on the market portfolio:
Asset A: rj = 0.09 + [0.80 × (0.13 − 0.09)] = 0.122 or 12.2%
Asset B: rj = 0.09 + [1.30 × (0.13 − 0.09)] = 0.142 or 14.2%
d. Asset A has the smaller beta, hence the smaller risk premium and required return. Specifically,
the risk premium is 3.2% (12.2% − 9%)—compared with 5.2% for Asset B’s (14.2% − 9%).
b. Using the CAPM equation: rA = RF + [𝛽 × (rm − RF)], where RF is the risk-free rate (here 8%),
𝛽 the beta on asset A (here 1.1), and rm the return on the market portfolio (here 12%), solve for
rA is the required return on asset A: rA = 8% + [1.1 × (12% − 8%)] = 8% + 4.4% = 12.4%.
c. Using the CAPM equation, rA = RF + [𝛽 × (rm − RF)], with RF = 6%, 𝛽 = 1.1, and rm = 10%,
solve for rA = 6% + [1.1 × (10% − 6%)] = 6% + 4.4% = 10.4%.
d. Using the CAPM equation, rA = RF + [𝛽 × (rm − RF)], with RF = 8%, 𝛽 = 1.1, and rm = 13%,
solve for rA = 8% + [1.1 × (13% − 8%)] = 8% + 5.5% = 13.5%.
e. (1) A decline in inflationary expectations reduces required return by the same amount for every
beta—that is, produces a parallel downward shift of the SML. (2) Increased risk aversion gives
the SML a steeper slope because a higher return is now be required for each beta.
e. When investor risk aversion declines, investors require lower returns for any given risk level
(beta). The SML will rotate clockwise about the fixed risk-free rate (because the risk premium for
an zero-beta asset will remain zero).
This case requires students to use standard deviation, coefficient of variation, and CAPM to assess the
trade-off between risk and return for two possible investments.
( Pt − Pt −1 + Ct )
a. Actual annual return for period t is given by rt = ,
Pt −1
where Pt is the end-of-year value, Pt-1 is the beginning-of-year value, and Ct is cash flow during the year.
where rt is return in year t, r is average return over n years, and n is the number of years. For Asset X:
0.071297
σx = = 0.07922 = 0.0890 = 8.90%
10 − 1
Coefficient of Variation (CVx) = σx ÷ 𝑟̅x = 8.90% ÷ 11.74% = 0.76
0.006955
σY = = 0.0773 = 0.0278 = 2.78% , and CVy = σy ÷ 𝑟̅y = 2.78% ÷ 11.14% =
10 − 1
0.25.
c. Summary statistics Asset X Asset Y
Expected return 11.74% 11.14%
Standard deviation 8.90% 2.78%
Coefficient of variation 0.76 0.25
Comparing expected returns calculated in part (a), Asset X provides a return only slightly above that
from Asset Y. At the same time, both the standard deviation of returns and coefficient of variation for
Asset X are roughly three times greater than that for Asset Y. So Asset X appears significantly riskier
than Asset Y. But the problem notes Mr. Sayou is choosing between X and Y to add to a diversified
portfolio. That means he should care only about the nondiversifiable risk of the two assets. Standard
deviation and coefficient of variation are measures of the total volatility of returns from both
diversifiable and nondiversifiable shocks. For this reason, the better asset cannot be determined.
d. Using the CAPM equation: rj = RF + [𝛽 × (rm − RF)], where rj is the required return on asset j,
RF the risk-free rate, 𝛽 the beta on asset j, and rm the return on the market portfolio, the required returns
on Asset X and Y are:
CAPM Required Expected Return
Asset RF + [𝜷j × (rm − RF)] = Return Part (a)
X 7% + [1.6 × (10% − 7%)] = 11.8% 11.74%
Y 7% + [1.1 × (10% − 7%)] = 10.3% 11.14%
Of the two assets, only Asset Y offers an expected return above the required return determined by
CAPM. Moreover, required return is calculated with the correct risk measure—beta—which captures
nondiversifiable risk.
e. Mr. Sayou wants to add X or Y to a diversified portfolio, so he should care only about the
nondiversifiable risk of the two assets. [Standard deviation and coefficient of variation measure total
volatility of returns from both diversifiable and nondiversifiable shocks.] CAPM will indicate the
required return for the two assets based on their nondiversifiable risk (𝛽 x = 1.60 and 𝛽 y = 1.10). As noted,
of the two assets only Y offers an expected return above required return (based on nondiversifiable risk).
So Asset Y should be recommended.
f. (1) A one percentage point rise in expected inflation will boost the risk-free rate to 8% and market
return to 11% and have the following effect on rx and ry:
CAPM: Required Expected Return
Asset RF + [bj × (rm − RF)] = Return (rj) Part (a)
X 8% + [1.6 × (11% − 8%)] = 12.8% 11.74%
Y 8% + [1.1 × (11% − 8%)] = 11.3% 11.14%
Now, neither asset offers an expected return greater than required return.
(2) If investors become less risk averse, causing market return to fall to 9%, rx and ry will change to:
CAPM Required Expected Return Difference
Asset RF + [bj × (rm − RF)] = Return (rj) Part (a) (Percentage Points)
X 7% + [1.6 × (9% − 7%)] = 10.2% 11.74% 1.54
Y 7% + [1.1 × (9% − 7%)] = 9.2% 11.14% 1.94
The drop in market return causes required return to fall below expected returns for both assets. If
limited to one asset, Mr. Sayou should choose Y because it provides the larger return compared with
required return (and does so with less nondiversifiable risk).
Spreadsheet Exercise
Answers to Chapter 8’s stock portfolio analysis spreadsheet problem are available
on www.pearson.com/mylab/finance.
Group Exercise
Group exercises are available on www.pearson.com/mylab/finance.
This exercise will give students insight into the world of stock-market analysis. Each group is asked to obtain
stock-market data from several websites on the recent performance of its shadow firm and compare the
numbers with a relevant market index over one and five years. Students will calculate annual returns,
investigate correlation between returns and the market return, and graph the results. As always, the instructor
can modify the exercise the meet class needs, perhaps by adding other corporations to the comparison(s) and
dropping more complex calculations.