Question

1. Based on Belfry's earnings history over the past 15 years, which have covered various states of the economy, the venture capital execs want Belfry to estimate their overall returns. Given the following estimates of economy over the next several years, determine Belfry's expected rate of return. (6 pts)      

Note, this type of development firm has much higher than normal returns under normal and boom conditions. The probability of each state of the economy reflects the current situation, not necessarily historic market conditions for the firm.               

State of the Economy	Current Probability of State of the Economy	Rate of Return if State Occurs
Boom	15%	28.00%
Normal	50%	17.00%
Recession	35%	-20.00%

Expected return for “average” company project (based on assumed economic probabilities) =

Historically, Belfry projects have had an average beta of 1.5. Assuming the market risk premium (MRP) currently estimated to be 7.5% and the risk-free rate is 0.95%, what is the required return for an "average" Belfry project using based on its average project beta? Round the average required return to 2 decimal places (x.xx%).     (6 pts)

Expected return for “average” company project (based on current estimated MRP) =

Answer 1

1)

Expected return for “average” company project = 0.15*0.28 + 0.5*0.17 + 0.35*(-0.2)

Expected return for “average” company project = 0.042 + 0.085 - 0.07

Expected return for “average” company project = 0.057 or 5.70%

2)

return for “average” company project (based on current estimated MRP) = Risk free rate + beta(market risk premium)

return for “average” company project (based on current estimated MRP) = 0.95% + 1.5(7.5%)

return for “average” company project (based on current estimated MRP) = 0.95% + 11.25%

return for “average” company project (based on current estimated MRP) = 12.20%