BBMF 3823 CORPORATE FINANCE

TUTORIAL 7 BUSINESS VALUATION: RISK,RATES OF RETURN,STOCK

VALUATION

1. Define the security market line. If a security is undervalued in terms of the capital-asset
pricing model, what will happen if investors come to recognize this undervaluation?

The Security Market Line (SML) illustrates the Capital Asset Pricing Model (CAPM), showing
the relationship between expected return and systematic risk. Undervaluation occurs when a
security's expected return is higher than its market price. If investors recognize this
undervaluation, increased demand for the security will push its price higher until it aligns with its
intrinsic value according to the CAPM.

2. Mulherin’s stock has a beta of 1.23, its required return is 8.75%, and the risk-free rate is
4.30%. What is the required rate of return on the market?

8.75=4.3+1.23(Erm-4.3)

= 7.92%

3.Mikkelson Corporation's stock had a required return of 13.50% last year, when the risk-
free rate was 5.50% and the market risk premium was 4.75%. Then an increase in
investor risk aversion caused the market risk premium to rise by 2%. The risk-free rate
and the firm's beta remain unchanged. What is the company's new required rate of
return?

Expected Return = 13.50%

Risk Free Rate of Return = 5.50%
Market Premium = 4.75%

ER = RF + β*MP
Thus, β = (ER - RF)/MP
β = 1.68

Risk Free Rate of Return = 5.50%

β = 1.68
Market Premium = 4.75% + 2% = 6.75%
ER = RF + β*MP
= 5.50 + 1.68*6.75
= 16.84%

The company's new required rate of return

would be 16.84%

4. Taggart Inc.'s stock has a 50% chance of producing a 21% return, a 30% chance of
producing a 10% return, and a 20% chance of producing a -28% return. What is the
firm's expected rate of return?

Probability Return P*r

(P) (r)
0.5 0.21 0.105
0.3 0.1 0.03
0.2 -0.28 -0.056

Expected Rate of Return= 0.105+0.03+(-0.056)

=0.079
= 7.9%

5. Why is beta a measure of systematic risk? What is its meaning?

Systematic risk is measured by beta coefficient, which estimates the extent to which a
particular investment’s returns vary with the returns on the market portfolio.
Beta tells us how closely an investment's performance tracks with changes in the broader
market. It reflects the degree to which an investment is affected by systematic factors that
impact the entire market, such as economic trends, interest rates, or political events.

High Beta (β > 1): Investment's returns move more than the market, indicating higher
sensitivity to market fluctuations and higher systematic risk.

Low Beta (β < 1): Investment's returns move less than the market, suggesting lower sensitivity
to market movements and lower systematic risk.

Beta of 1 (β = 1): Investment's returns move in line with the market, indicating proportional
systematic risk.

6. What is the required rate of return of a stock? How can it be measured?

The required rate of return of a stock, also known as the expected return, is the minimum return
an investor expects to achieve for holding that stock. It represents the compensation investors
demand for taking on the risk associated with investing in that particular stock.

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BBMF 3823 CORPORATE FINANCE

Capital Asset Pricing Model (CAPM) is a widely used model in finance that calculates the
required rate of return based on the stock's beta, the risk-free rate, and the market risk premium.
The formula is: 𝑅𝑖=𝑅𝑓+𝑖𝛽×(𝑅𝑚−𝑅𝑓)

Ri = required rate of return of the stock

Rf = risk-free rate of return
βi = beta of the stock
Rm = expected return of the market

Equation implies that higher the systematic risk of an investment, other things remaining the
same, the higher will be the expected rate of return an investor would require to invest in the
asset.

7. Describe market risk and diversifiable risk.

Market risk, also known as systematic risk or non-diversifiable risk, arises from factors that
impact the entire market or specific segments, such as interest rate fluctuations, economic trends,
and political instability. It cannot be eliminated through diversification as it affects all
investments to some extent. Investors expect compensation for bearing this risk, typically in the
form of a risk premium.

On the other hand, diversifiable risk, also known as unsystematic or specific risk, pertains to
risks unique to individual assets or investments, like company-specific issues, industry changes,
or isolated events. Diversification across different assets, industries, and regions can effectively
mitigate diversifiable risk by spreading exposure, thereby reducing its impact on overall portfolio
returns.

8. Jerome J. Jerome is considering investing in a security that has the following distribution
of possible one-year returns:

Probability of 0.1 0.2 0.3 0.3 0.1

 occurrence
Possible return -0.1 0.0 0.1 0.2 0.3

What is the expected return and standard deviation associated with the investment?

Possible return Probability of Step 2 Step 3

occurrence

B C D=B*C E=[B-E(R)]^2 F=E*C

-0.1 0.1 -0.01 0.0441 0.00441

0.0 0.2 0 0.0121 0.00242

0.1 0.3 0.03 0.0001 0.00003

0.2 0.3 0.06 0.0081 0.00243

0.3 0.1 0.03 0.0361 0.00361

Expected rate of return

=(0.1*-10%)+(0.12*0%)+(0.3*10%)+(0.3*20%)+(0.1*30%)
=11%

Variance
=0.00441+0.00242+0.0003+0.00243+0.00361
=0.0129

Standard deviation
=√0.0129
=0.1136
=11.36%

9. Stock X has a 9% expected return, a beta coefficient of 0.8 and a 30% standard
deviation of expected returns. Stock Y has 14% expected return, a beta coefficient of 1.3
and a 20% standard deviation. The risk free rate is 5% and market risk premium is 6.5%.

a. Calculate the coefficient of variation of each stock.

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BBMF 3823 CORPORATE FINANCE

Coefficient of Variation (CV) = (standard deviation/ expected return)

Stock X
CV = 0.30/ 0.09
= 3.33%
Stock Y
CV = 0.2/0.14
= 1.43%
b. Which stock is riskier than the other stock?

Stock X is riskier than Stock Y. It is because Stock X and Stock Y have the same unit of return
but CV of Stock X is higher than Stock Y means that the risk per unit of return is higher.

c. What is the required return of each stock?

Required Rate of Return (RRR) = Rf+ ß(Rm– Rf )
Rf = risk-free rate of interest
βi = the beta coefficient of the stock
Rm = the expected rate of return on the market portfolio
Rf = the risk-free rate of interest

(Rm−Rf) = the market risk premium

Stock X
RRR = 0.05 + 0.8(0.065)
= 0.102
= 10.20%
Stock Y
RRR = 0.05 + 1.3(0.065)
= 0.1345
= 13.45%
d. Calculate the required of a portfolio if $8000 is invested in stock X and $2000 is invested
in stock Y.
Given:

$8000 is invested in Stock X

$2000 is invested in Stock Y

Assume

Wx as the proportion of the portfolio invested in Stock X

Wy as the proportion of the portfolio invested in Stock Y

The weights Wx & Wy can be calculated as follows:

Wx = 8000/ (8000 + 2000) = 0.8

Wy = 2000/ (8000 + 2000) = 0.2

βP = β1 x ω1 + β2 x ω2 + … + βn x ωn

βPx = 10.20%
βPy = 13.45%
βP = (0.102 x 0.8) + (0.1345 x 0.2)
= 0.0816 + 0.0269
= 0.1085 x 100%
= 10.85%
10. A stock’s returns have the following distribution

Demand for company product probability of this demand rate of return

Weak 10% (50%)
Below average 20% (5%)
Average 40% 16%
Above average 20% 25%
Strong 10% 60%
_____
100%

Calculate the stock’s expected return , standard deviation and coefficient of variation

Demand for Probability rate of return Step 2 Step 3

company of this (r)
product demand
(Pb)

A B C D=B*C E = [C − F = E*B

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BBMF 3823 CORPORATE FINANCE

E(R)]2
Weak 10% -0.5 0.1*(-0.5) 0.376996 0.0376996
= -0.05

Below 20% -0.05 0.2*(-0.05) 0.026896 0.0053792

average =-0.01

Average 40% 0.16 0.4*0.16 0.002116 0.0008464

=0.064

Above 20% 0.25 0.2*0.25 0.018496 0.0036992

average =0.05

Strong 10% 0.6 0.1*0.6 0.236196 0.0236196

=0.06

Expected Return E(r)=[(0.1*(-0.5)]+ ［ (0.2* （ -0.05) ］

+(0.4*0.16)+(0.2*0.25)+(0.1*0.6)]
= 0.114
=11.4%

Variance
= 0.0376996 + 0.0053792+ 0.0008464+ 0.0036992 + 0.0236196
= 0.071244
= 712.42

standard deviation
=√[(0.0376996*0.1)+(0.0053792*0.2)+(0.0008464*0.4)+(0.0036992*0.2)+(0.0236196*0.1)]
=√0.071244
= 0.2669
= 26.69%

coefficient of variation
= 26.69/ 11.4
= 2.34%