Fundamentals Of Corporate Finance

7th Edition Ross Solutions Manual

Visit to download the full and correct content document: https://testbankdeal.com/dow
nload/fundamentals-of-corporate-finance-7th-edition-ross-solutions-manual/
Chapter 10—Lessons from capital market history: Solutions to questions and problems
1 Approximate real rate = 0.06 − 0.0175 = 0.0425 = 4.25%
Exact real rate = (1.06)/(1.0175) − 1 = 0.04177 = 4.18%

2 Expected inflation rate = (1.12)/(1.0655) − 1 = 0.05 = 5%

3 Percentage return = (4.615 + 0.246 − 5.50)/5.50 × 100% = –11.6%

4 Dividend yield = 0.246/5.50 × 100% = 4.47%

Capital gains yield = (4.615 − 5.50)/5.50 × 100% = –16.09%

5 Percentage return = (6.194 + 0.246 − 5.50)/5.50 × 100% = 17.09%

Dividend yield = 0.246/5.50 × 100 = 4.47 %
Capital gains yield = (6.194 − 5.50)/5.50 × 100% = 12.62%

6 R = (1 + 0.02)*(1 + 0.03) – 1 = 0.0506 = 5.06%

7 Rb = (0.08 + 0.05 − 0.06 + 0.07+ 0.12)/5 = 0.052 = 5.2%

b = {[(0.08 − 0.052)2 + (0.05 − 0.052)2 + (–0.06 − 0.052)2 + (0.07 −
0.052)2 + (0.012 − 0.052)2]/(5 − 1)}0.5
= {[0.000784 + 0.000004 + 0.012544 + 0.000324 + 0.004624]/4}0.5
= {0.00457}0.5
= 0.067602 = 6.76%
Rs = (0.15 − 0.04 − 0.09 + 0.11 + 0.06)/5 = 0.038 = 3.8%
s = {[(0.15 − 0.038)2 + (–0.04 − 0.038)2 + (–0.09 − 0.038)2 + (0.11 − 0.038)2 +
(0.06 − 0.038)2]/(5 − 1)}0.5
= {[ 0.012544 + 0.006048 + 0.016384 + 0.005184+ 0.000484]/4}0.5
= {0.01017}0.5
= 0.100846 = 10.0846%

1
Solutions manual t/a Fundamentals of Corporate Finance 7e, Ross et al
Copyright © 2016 McGraw-Hill Education (Australia) Pty Ltd
8a The average return was (9.1 + (–4.7) + (–1.7) + 21.6 + 26.4 + 23.9 + 25.4 + (–15.5) +
(–26.0) + 9.6 + 7.7)/11 = 6.89% Nominal (Arithmetic average)
The average inflation rate was 3.21%.
b The real rate of return was therefore (1.0689)/(1.0321) – 1 = 3.56%

9 From Table 10.2

Total
perio
d
Ordinary share 14.42%
Small share 18.02%
90-day bank bill 8.97%
10-yr government 9.08%
bond
Inflation 4.77%

Real returns.
Government bonds = (1.0908)/(1.0477) – 1 = 4.11%
Bank bills = (1.0897)/(1.0477) – 1 = 4.01%
Small company shares = (1.1802)/(1.0477) – 1 = 12.65%

Both returns (small company shares and government bonds) are acceptable given their
level of risk. Table 10.3 has identified the risk premium on small shares and Table 10.4
tells us the standard deviation of small shares was 31.68%, whereas the standard
deviation of government bonds was only 3.49%. Remember, the real return is an
average return and there is no guarantee that a specific company will return this
amount: the range of return as indicated by the standard deviation is quite large.
However, we could be very confident that an investment in any series of government
bonds would return around 4.11% (real). The risk we bear is related to inflation not the
return on the government bonds.

2
Solutions manual t/a Fundamentals of Corporate Finance 7e, Ross et al
Copyright © 2016 McGraw-Hill Education (Australia) Pty Ltd
10a d = (5.5 – 8.97)/4.4 = -0.79 where
8.97 = Average return on bank bills
4.4 = Standard deviation of the average return on bank bills
From Table A.5 the probability of N(d) = -0.79 is 0.215 so there is only a
21.5% chance of getting a return less than 5.5 per cent.
b 95 per cent is -2 to + 2 = 8.97 – 2(4.4) to 8.97 + 2(4.4)
= 0.2% to 17.8%
c When d is –2.6 standard deviations below the mean there is 0.0047 probability
of the value being less, and when d is 2.6 standard deviations above the mean
there is 0.0047 probability of the value being more. In the range of 2.6 standard
deviations either side of the mean there is 99.06 per cent of the distribution (i.e.
1 – 2(0.0047) = 0.9906). So the required range is from:
8.97 – 2.6(4.4) to 8.97 + 2.6(4.4)
= 9.26 – 11.44 to 9.26 + 11.44
= −2.5 per cent to 20.4 per cent.

11  = 31.68% therefore 3.16 s = 100%

Money will double at approximately 3.16 standard deviations above the mean.
Assuming normality, this will occur less than 1% of the time: it is rarely seen and
should not happen in every century.

12 It is impossible to lose more than 100% of your investment. Thus, return distributions
are truncated at –100%.

13 A negative real rate implies that the inflation rate exceeds the nominal rate. Certainly
this has happened in the past, but it is unlikely that securities would be priced before the
fact with a negative real rate. A negative inflation rate implies that there is deflation,
which Japan has been experiencing recently. More recently, the United States
experienced a short period of mild deflation after the Global Financial Crisis.

14 Yes. The market is weak-form efficient, as a strong-form efficient market incorporates

all private and publicly-available information, and historic share prices are publicly
available information.

3
Solutions manual t/a Fundamentals of Corporate Finance 7e, Ross et al
Copyright © 2016 McGraw-Hill Education (Australia) Pty Ltd
15a
Ordinary shares Bonds Premium
1997 26.60% 7.80% 18.80%
1998 1.60% 6.10% –4.50%
1999 15.30% 5.50% 9.80%
2000 15.50% 6.40% 9.10%
2001 9.10% 5.80% 3.30%
2002 –4.70% 6.00% –10.70%
2003 –1.70% 5.40% –7.10%
2004 21.60% 5.50% 16.10%
2005 26.40% 5.50% 20.90%
2006 23.90% 5.40% 18.50%
2007 25.40% 5.80% 19.60%
2008 –15.50% 6.20% –21.70%
2009 –26% 5.00% –31.00%

b
Ordinary Shares Bonds Premium
Average 9.04% 5.88% 3.16%

c
Ordinary Squared Bonds Squared Premium Squared
Shares Deviation Deviation Deviation
1997 26.60% 1.75% 7.80% 0.03% 18.80% 1.30%
1998 1.60% 1.38% 6.10% 0.00% –4.50% 1.42%
1999 15.30% 0.04% 5.50% 0.00% 9.80% 0.06%
2000 15.50% 0.05% 6.40% 0.00% 9.10% 0.03%
2001 9.10% 0.18% 5.80% 0.00% 3.30% 0.17%
2002 –4.70% 3.26% 6.00% 0.00% –10.70% 3.28%
2003 –1.70% 2.27% 5.40% 0.00% –7.10% 2.11%
2004 21.60% 0.68% 5.50% 0.00% 16.10% 0.75%
2005 26.40% 1.70% 5.50% 0.00% 20.90% 1.82%
2006 23.90% 1.11% 5.40% 0.00% 18.50% 1.23%
2007 25.40% 2.68% 5.80% 0.00% 19.60% 2.70%
2008 –15.50% 6.02% 6.20% 0.00% –21.70% 4.71%
2009 –26% 12.28% 5.00% 0.01% –31.00% 9.61%
Average 9.04% 5.88% 3.16%
Variance 2.78% 0.00% 2.43%
Standard
deviation 16.68% 0.57% 15.60%

4
Solutions manual t/a Fundamentals of Corporate Finance 7e, Ross et al
Copyright © 2016 McGraw-Hill Education (Australia) Pty Ltd
d The risk premium can be negative, but such a relationship is unlikely to persist for any length
of time. It would occur in a falling market.

16 They were highest in the early 1980s. This was during a period of high inflation and is
consistent with the Fisher effect.

17a Annual nominal earnings (R) = 0.85 × 0.12 + 0.15× 0.03

= 0.102 + 0.0045
= 0.1065
Real earnings (r) = (1 + R)/(1 + h) − 1
= 1.1065/1.04 − 1
= 0.0639
Annual withdrawal rate ( w ) = 48 000/650 000
= 0.07384
Excess of withdrawal rate over real rate = 0.0639 − 0.07384 = 0.00994 = 0.99%

The withdrawal rate is just above the real earnings rate which means real capital
is decreasing each year.
b Rate to provide current withdrawals plus inflation = [(1 + R)(1 + h)] − 1
= [1.07384 × 1.04] – 1
= 0.1167936

Let x be the proportion to be invested in the diversified portfolio to earn 12% or 0.12
0.1167936 = 0.12x + (1 – x) 0.03
0.1167936 − 0.03 = 0.12x – 0.03x
0.0867936 = 0.09x
0.9644 = x
so that 96.44 % is invested in the diversified portfolio and 3.56 % invested in
the fixed portfolio.
Expected nominal return = 0.9644 × 0.12 + 0.0356 × 0.03
= 0.1157 + 0.0011
= 0.1168
Expected real return = 1.1168/1.04 – 1 = 0.738
Withdrawal rate = 0.0738 as above

18 On average, the only return that is earned is the required return. There is still a return;
however, there is no above-normal return and this is the return a positive NPV provides.

19 Ignoring trading costs, on average, such investors merely earn what the market offers;
the trades all have zero NPV. If trading costs exist, then these investors lose by the
amount of the costs.

5
Solutions manual t/a Fundamentals of Corporate Finance 7e, Ross et al
Copyright © 2016 McGraw-Hill Education (Australia) Pty Ltd
20 Let: h = inflation rate
RS = nominal rate on some security
RT = nominal rate on government bonds
rS = real rate on some security
rT = real rate on government bonds
so: rS − rT = real risk premium, RPR
[(1 + RS) /(1 + h) − 1] − [(1 + RT)/(1 + h) − 1] = RPR
((1 + RS) − (1 + RT))/(1+h) = RPR
(RS − RT) /(1 + h) = RPN/(1 + h) = RPR = real risk premium.

21 Unlike gambling, the share market is a positive sum game; everybody can win. This is
because there is still a return even though, as discussed in the last question, the NPV
may be zero. Also speculators provide liquidity to markets and thus help promote
efficiency through price discovery.

22 The analyst is identifying mispriced securities based on historical information. If this

was possible, then it would be argued that the weak form of market efficiency does not
hold. This would also mean that the semi-strong and strong forms of the efficient
market hypothesis also do not hold.

23a
Company Company debt Government
shares debt
Average 0.18432 0.07103 0.0353

Year Deviations from average return

Company Company debt Government debt
shares
2006 0.08108 –0.05643 –0.0269
2007 0.09418 0.06537 0.0266
2008 0.03988 0.00447 –0.0083
2009 –0.01172 –0.09566 –0.0025
2010 –0.20342 0.08227 –0.0055
Total 0.0000 0.0000 0.0000

6
Solutions manual t/a Fundamentals of Corporate Finance 7e, Ross et al
Copyright © 2016 McGraw-Hill Education (Australia) Pty Ltd
 We square these deviations to calculate the variances and standard deviations:

Squared deviations from average return

2006 0.006574 0.003184 0.000724
2007 0.00887 0.004273 0.000708
2008 0.00159 0.00002 0.0000689
2009 0.000137 0.009155 0.00000625
2010 0.04138 0.006768 0.00003038
Variance 0.014638 0.00585 0.000384
Standard deviation 0.120987 0.076486 0.019599

To calculate the variances, the squared deviations were added and divided by 4
(the number of returns less 1).
b Company share returns (18.43%) are higher than debt of 7.13% and government
debt of 3.53% because they have more risk. Note the standard deviation is
0.12098 [12.10%] compared to company debt’s standard deviation of 0.07649
[7.64%]. While both returns are dependent upon the earnings of the company,
the debt would be paid first if profits were insufficient to cover returns to both
and in addition debt is likely to be secured by the company’s assets.
c Company debt returns are higher than government debt returns. Government
debt is almost risk-free, as is shown by the standard deviation of 1.96%
compared to 7.64% for company debt. The lower the risk, the lower the return,
or conversely the higher the risk, the higher the return.

7
Solutions manual t/a Fundamentals of Corporate Finance 7e, Ross et al
Copyright © 2016 McGraw-Hill Education (Australia) Pty Ltd
SOLUTIONS TO MINICASE
1 The biggest advantage the mutual funds have is instant diversification. The mutual
funds have a number of assets in their portfolios.

2 Both the APR and EAR are infinite. The match is instantaneous, so the number of
periods in a year is infinite.

3 The advantage of the actively managed fund is the possibility of outperforming the
market, which the fund has done six of the last eight years. The major disadvantage is
the likelihood of underperforming the market. In general, most mutual funds do not
outperform the market for an extended period of time, and finding the funds that will
outperform the market in the future beforehand is a daunting task. One factor that
makes outperforming the market even more difficult is the management fee charged by
the fund.

4 The returns are the most volatile for the small cap fund because the stocks in this fund
are the riskiest. This does not imply the fund is bad, just that the risk is higher and
therefore the expected return is higher. You would want to invest in this fund if your
risk tolerance is such that you are willing to take on the additional risk in the hope of a
higher return. The higher expenses of the fund are expected. In general, small cap funds
have higher expenses, in large part due to the greater cost of running the fund, including
researching smaller stocks.

5 Since we are given the average return for each fund over the past 10 years, we should
use the average risk-free rate over the same period. So, using the information from the
Table below, the 10-year average risk-free rate is:
Risk-free rate = (0.0486 + 0.0480 + 0.0598 + 0.0333 + 0.0161 + 0.0094 + 0.0114 +
0.0279 + 0.0497 + 0.0452)/10
Risk-free rate = 0.0349 or 3.49%

The Sharpe ratio for each of the mutual funds and the company stocks are:
Bledsoe S&P 500 Index Fund = (11.48% – 3.49%)/15.82% = 0.5048
Bledsoe Small-Cap Fund = (16.68% – 3.49%)/19.64% = 0.6714
Bledsoe Large Company Stock Fund = (11.85% – 3.49%)/15.41% = 0.5422
Bledsoe Bond Fund = (9.67% – 3.49%)/10.83% = 0.5703
S&S Air stock = (18% – 3.49)/70% = 0.2072

The Sharpe ratio is most appropriate to a diversified portfolio, and is least appropriate
to the company stock.

6 This is a very open-ended question. The asset allocation depends on the risk tolerance
of the individual. However, most students will be young, so in this case, the portfolio
allocation should be more heavily weighted toward stocks.
In any case, there should be little, if any, money allocated to the company stock. The
principle of diversification indicates that an individual should hold a diversified
8
Solutions manual t/a Fundamentals of Corporate Finance 7e, Ross et al
Copyright © 2016 McGraw-Hill Education (Australia) Pty Ltd
portfolio. Investing heavily in company stock does not create a diversified portfolio.
This is especially true since income comes from the company as well. If times get bad
for the company, employees face layoffs or reduced work hours. So, not only does the
investment perform poorly, but income may be reduced as well. We only have to look
at employees of Enron or WorldCom to see the potential for problems with investing in
company stock. At most, 5 to 10 per cent of the portfolio should be allocated to
company stock.
Age is a determinant in the decision. Older individuals should be less heavily weighted
toward stocks. A commonly used rule of thumb is that an individual should invest 100
minus their age in stocks. Unfortunately, this rule of thumb tends to result in an
underinvestment in stocks.

9
Solutions manual t/a Fundamentals of Corporate Finance 7e, Ross et al
Copyright © 2016 McGraw-Hill Education (Australia) Pty Ltd