Question

1. Going forward, the stock market and Bananarama’s stock price have the following probability distribution:

Stock Market                                Bananarama Stock           

Probability                                      Rate of Return                                Rate of Return                        

0.2                                                  (4%)                                                   (6%)

0.6                                                   8%                                                     10%

0.2                                                  14%                                                   20%                  

(a) Calculate the expected rate of return for the stock market and for Bananarama’s stock.

                        Expected rate of return

b) Is Bananarama’s stock more volatile or less volatile that the stock market in genera

(c) Is the Beta for Bananarama’s stock lower or higher that 1.0?

(d) Is Bananarama’s cost of equity higher or lower that the stock market’s average cost of equity?

(e) Why?

Answer 1

		Expected Return =Mean Return =SUMof ((Probability)*(Return))
		Variance of Return =Sum of(Probability* (Deviation ^2))
		Deviation =Return -Mean Return
		Standard Deviation of Return =Square Root of Variance of Return
		ANALYSIS OF STOCK MARKET RETURN
			p	R1	A1=R1*P	D1=R1-6.8	E1=(D1^2)	F1=p*E1
			Probability of Return	Return(%)	Probability*Return(%)	Deviation(%)	Deviation Squared(%%)	Probability*Deviation Squared(%%)
			0.2	-4.00	-0.80	-10.80	116.64	23.328
			0.6	8.00	4.80	1.20	1.44	0.864
			0.2	14.00	2.80	7.20	51.84	10.368
				SUM	6.80		SUM	34.56
		Expected Return =Mean return	6.80	%
		Variance of Return	34.56	%%
		Standard Deviation of Return =SQRT(34.56)=		5.88	%
		ANALYSIS OF BANANARAMA RETURNS
			p	R2	A2=R2*p	D2=R2-8.8	E2=(D2^2)	F2=p*E2
			Probability	Return(%)	Probability*Return(%)	Deviation(%)	Deviation Squared(%%)	Probability*Deviation Squared(%%)
			0.2	-6	-1.2	-14.8	219.04	43.808
			0.6	10	6	1.2	1.44	0.864
			0.2	20	4	11.2	125.44	25.088
				SUM	8.8		SUM	69.76
		Expected Return =Mean return	8.8	%
		Variance of Return	69.76	%%
		Standard Deviation of Return =SQRT(69.76)=		8.35	%
		COVARIANCE BETWEEN RETURNS OF Market STOCK RETURN AND BANANARAMA RETURNS
		Covariance =SUM of (Probability*Deviation of MarketStock* Deviation of Bananarama)
			p	D1=R1-15.5	D2=R2-16.8	G=p*D1*D2
			Probability	Deviation of Market	Deviation of Bananarama	probability*Deviation Market*Deviation Bananarama
			0.2	-10.8	-14.8	31.968
			0.6	1.2	1.2	0.864
			0.2	7.2	11.2	16.128
					SUM	48.96
		Covariance of return Market and Return Bananarama	48.96	%%
	a)	Expected Return of stock market	6.80	%
		Expected Return of Bananarama	8.8	%
	b)	Standard Deviation of stock market returns	5.88	%
		Standard Deviation of Bananarama stock return	8.8	%
		Standard Deviation of Bananarama stock return is higher than Standard Deviation of Stock Market
		Hence,Bananarama Stock is more volatile than market
	c)	Beta of Bananarama Stock=Covariance(Market, Banannarama)/(Variance of Market Returns)
	A	Covariance of return Market and Return Bananarama	48.96	%%
	B	Variance of Return of stock market	34.56	%%
	C=A/B	Beta of Bananarama Stock	1.416666667
		Beta of Bananarama Stock is higher than 1.0
	d)	Bananrama' s cost of equity is higher than average stock market cost of equity
	(e)	As per CAPM equation,
		(Expected return of Banarama's Stock)-Rf=Beta *(Rm-Rf)
		Rf=Risk Free Rate, Rm=Market rate
		Since Beta is greater than 1,
		Expected Return of Bananarama's equity is higher than market return
		Hence cost of equity of Bananarama is higher