Chapter 8 Part 2

P8–1 Rate of return A financial analyst for Smart Securities Limited, Paul Chan, wishes to
estimate the rate of return for two similar-risk investments, A and B. Paul’s research indicates
that the immediate past returns will serve as reasonable estimates of future returns. A year ago,
investment A and investment B had market values of $63,000 and $35,000, respectively. During
the year, investment A generated cash flows of $6,100, and investment B generated cash flows of
$2,800. The current market values of investments A and B are $71,000 and $32,000,
respectively.
a. Calculate the expected rate of return on investments A and B using the most recent year’s
data.
b. Assuming that the two investments are equally risky, which one should Paul recommend?
Why?

Solutions to Problem
P8-1 Rate of return
Total return on an investment is given by:

where: rt = total return on asset Pt = Price of asset at time t-1

Pt = Price of asset at time t Ct = Cash received between t-1 and t
71,000−63,000+ 6,100
a. Investment A: Return ¿ =22.38 %
63,000
32,000−35,000+2,800
Investment B: Return ¿ =−0.57 %
35,000
b. Investment A should be selected because it has a higher rate of return for the same level
of risk.
P8–2 Return calculations for each of the investments shown in the following table, calculate the
rate of return earned over the unspecified time period
 Solutions to Problem
Return calculations
Total return on an investment is given by:

where: rt = total return on asset Pt = Price of asset at time t-1

Pt = Price of asset at time t Ct = Cash received between t-1 and t
Investment Calculation rt (%)

A ($20,100 − $23,400 − $2,800)  $23,400 –26.07

B ($324,000 − $225,000 + $16,000)  $225,000 51.11

C ($8,000 − $6,500 + $700)  $6,500 33.85

D ($46,500 − $36,600 + $3,580)  $36,600 36.83

E ($52,800 − $62,700 + $500)  $62,700 –16.59

P8–5 Risk and probability 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 accompanying 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?
 Solutions to Problem

P8-5 Risk and probability

a. Range is the difference between return with the best outcome and return with the worst.

Camera Range
R 30% - 20% = 10%
S 35% - 15% = 20%

b. Possible Probability Expected Return Weighted Value (%)

Camera Outcomes Pri ri (ri  Pri)
Pessimistic 0.25 20 5.00%
R Most likely 0.50 25 12.50%
Optimistic 0.25 30 7.50%
1.00 Expected return = 25.00%
Pessimistic 0.20 15 3.00%
S Most likely 0.55 25 13.75%
Optimistic 0.25 35 8.75%
1.00 Expected return = 25.50%
c. Camera S is riskier than Camera R because it has a broader range of outcomes. Note the
risk-return tradeoff because Camera S has more risk but also provides a higher return.

P8–7 Coefficient of variation Metal Manufacturing has isolated four alternatives for meeting its
need for increased production capacity. The following table summarizes data gathered relative to
each of these alternatives.
 Solutions to Problem
P8-7 Coefficient of variation

Coefficient of variation is given by : ,

σ
where r is the standard deviation of returns, and r is expected return
a. The coefficients of variation for projects A, B, C, and D are:
CVA = 7  20 = 0.35
CVB = 9.5  22 = 0.4318
CVC = 6  19 = 0.3157
CVD =5.5  16 = 0.34375
b. Project C has the lowest coefficient of variation, and hence this indicates relatively low
risk.
P8–8 Standard deviation versus coefficient of variation as measures of risk Greengage, Inc., a
successful nursery, is considering several expansion projects. All the alternatives promise to
produce an acceptable return. Data on four possible projects follow.

a. Which project is least risky, judging on the basis of range?

b. Which project has the lowest standard deviation? Explain why standard deviation may not be
an entirely appropriate measure of risk for purposes of this comparison.
c. Calculate the coefficient of variation for each project. Which project do you think Greengage’s
owners should choose? Explain why.
 Solutions to Problem

P8-8 Standard deviation versus coefficient of variation as measures of risk

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.

c. Coefficient of variation is given by : ,

σ
where r is the standard deviation of returns and r is expected return. The coefficients of
variation for projects A, B, C, and D are:

A: C:

B: D:
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 non-
diversifiable risk.

P8–24 Capital asset pricing model (CAPM) For each of the states of the economies shown in the
following table, use the capital asset pricing model to find the required return.

Solutions to Problem
P8-24 Capital asset pricing model—CAPM
 The CAPM equation is rj = RF + [j ´ (rm - RF)], where rj is the expected/required return on
asset j, j is beta for asset j, RF is the risk-free rate, and rm is the expected return on the
market portfolio:
Case rj = RF + [bj × (rm − RF)]

A 44.4% = 6% + [2.40 × (22% − 6%)]

B 0.5% = 3% + [–0.50 × (8% − 3%)]

C 14.5% = 10% + [0.90 × (15% − 10%)]

D 18.0% = 12% + [1.00 × (18% − 12%)]

E 8.5% = 5% + [0.70 × (10% − 5%)]

P8–26 Manipulating CAPM Use the basic equation for the capital asset pricing model (CAPM)
to work each of the following situations.
a. Find the required return for an asset with a beta of 2.2 when the risk-free rate and market
return are 5% and 32%, respectively.
b. Find the risk-free rate for a firm with a required return of 23.75% and a beta of 1.25 when the
market return is 20%.
c. Find the market return for an asset with a required return of 18% and a beta of 1.2 when the
risk-free rate is 8%.
d. Find the beta for an asset with a required return of 15% when the risk-free rate and market
return are 3% and 15%, respectively

Solutions to Problem
P8-26 Manipulating CAPM
a. rj = 5% + [2.2 × (32% − 5%)]
rj = 64.4%
b. 23.75% = RF + [1.25 × (20% − RF)]
RF = 5%
c. 18% = 8% + [1.2 × (rm − 8%)]
rm = 16.33%
d. 15% = 3% + [bj × (15% − 3%)
bj = 1
In a declining market, an investor should choose stock with a negative beta. When
the market return decreases, the return on C increases.

If you are expecting a potential market rally, an investor should choose an

aggressive stock like stock B. Its return will be higher than the market return in a
booming market.