8.06

EXPECTED RETURNS

Stocks A and B have the following probability distributions of expected future returns:

1. Calculate the expected rate of return, r_B, for Stock B (r_A = 15.10%.) Do not round intermediate calculations. Round your answer to two decimal places.
   %

2. Calculate the standard deviation of expected returns, σ_A, for Stock A (σ_B = 18.51%.) Do not round intermediate calculations. Round your answer to two decimal places.
   %

3. Now calculate the coefficient of variation for Stock B. Round your answer to two decimal places.

4. Is it possible that most investors might regard Stock B as being less risky than Stock A?

   1. If Stock B is more highly correlated with the market than A, then it might have a higher beta than Stock A, and hence be less risky in a portfolio sense.
   2. If Stock B is more highly correlated with the market than A, then it might have a lower beta than Stock A, and hence be less risky in a portfolio sense.
   3. If Stock B is more highly correlated with the market than A, then it might have the same beta as Stock A, and hence be just as risky in a portfolio sense.
   4. If Stock B is less highly correlated with the market than A, then it might have a lower beta than Stock A, and hence be less risky in a portfolio sense.
   5. If Stock B is less highly correlated with the market than A, then it might have a higher beta than Stock A, and hence be more risky in a portfolio sense.

1.Which of the following portfolios can not be on the Markowitz efficient frontier?

Portfolio Expected Return Standard Deviation
Q 15%    22.5%
R 15.75%    24.75%
S 17.25% 27.75%
T 18.75%    30%

2.You need to invest $20M in two assets: a risk-free asset with an expected return of 5% and a risky asset with an expected return of 15% and a standard deviation of 45%. You face a cap of 35% on the portfolio’s standard deviation. What is the maximum expected return you can achieve on your portfolio? Explain your reasoning. Whatis the corresponding Sharpe ratio of the portfolio with the maximum expected return? Explain your reasoning.

The Lubin’s Investment Team is considering investing in two securities, A and B, and the relevant information is given below:

What should the team do if they wish to earn 10% expected return on their portfolio?

What is the standard deviation of the team’s portfolio?

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?

Cede & Co. expects its EBIT to be $65,000 every year forever. The firm can borrow at 9 percent. The firm currently has no debt, its cost of equity is 15 percent, and the tax rate is 35 percent. Assume the firm borrows $173,000 and uses the proceeds to repurchase shares.

What is the cost of equity after recapitalization? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

1) Cost of equity?

What is the WACC? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

2) WACC?   

The Lubin’s Investment Team is considering investing in two securities, A and B, and the relevant information is given below:

Suppose the Team invested $7000 in security A and $3,000 in security B. Calculate the expected return and standard deviation of the Team’s portfolio.

Your company owns a large parcel of land in a neighboring city, which was purchased several years ago for $68,000 for a warehouse, which is no longer needed. Another company has offered you $20,000 per year for 20 years for the land. Due to some unusual financing arrangements your counter offer is for the $20,000 per year for 20 years plus an additional $10,000 six years from now and an additional $15,000 16 years from now. The other company agrees to the additional payments in years 6 and 16 but only if you agree to delay the start of the 20 equal $20,000 payments until three years from the date of agreement. By now, you and your boss are thoroughly confused. What is the present worth of each of the deals? Your company uses a MARR of 15% for this sort of analysis.

Which of the following statements are TRUE with respect to the relationship between option value and volatility/dividends/interest rates/time to maturity? I. when volatility decreases with all else remaining the same, both calls and puts increase in value. II. when dividends increases with all else remaining the same, puts increase in value while calls decrease in value. III. when interest rates decrease with all else remaining the same, calls decrease in value while puts increase in value. IV. when the time to maturity increases with all else remaining the same, both put and call European options always increase in value. Choose from the following:

II, III

I, II, III

I, II

I, III, IV

How the shape of yield curve might change when:

• Central bank adopts an explanatory monetary policy
• Market participants expect an increase in inflation in the future

John, James and Joe are all 35 years old and plan to retire at age 65. They expect to live to 90

years old. Upon retirement they would all like to take immediate annual pension payments

from their savings at the start of each year. John and James can access a quoted rate of 9% per

year with quarterly compounding whilst Joe can access a quoted rate of 11% per annum with

semi-annual compounding.

a) John has a monthly income of $6,000 and monthly expenses of $2350 and saves the

remainder at the end of each month. On the day of his retirement he will receive a

retirement bonus from his employer totaling $20,000 and will also sell his holiday home

for an estimated $150,000. How much money will John have saved upon retirement?

b) What would be John’s annual pension?

c) James does not have a holiday home to sell, and will not be receiving a bonus from his

employer upon retirement. However he is able to invest twice as much as John each

month. How much later can James start saving if he wants to have the same annual

pension as John?

d) Joe also does not have a holiday home to sell, and will not be receiving a bonus from his

employer upon retirement. Unfortunately he does not believe he can save any money

during the first 5 years. However, he anticipates being able to save $6,000 per month for

the subsequent 10 years, and then $8,000 per month until retirement. Comparing Joe

with John, who has the biggest annual pension, and by how much?

use a financial calculator to solve. (BAIIplus)

effective interest rate= (1+ r/m)^m/f

make a timeline for each person.

Based on the following assumptions, calculate the Contribution Margin and the Contribution Income Statement.

Assumptions:

1. 250 Units are Sold

2. Per Unit cost is $75

3. Variable costs = $35 per unit

4. Fixed costs are $3,500

a. What is the Revenue?

b. What are the Variable costs?

c. What is the Contribution Margin?

d. What is the Operating Income?

Does a mergers affect the cash flow, dividends, WACC and CAPM? If so, how and to what extend?

Stock A has a beta of 1.8 and an expected return of 20 percent. Stock B has a beta of 1.2 and an

expected return of 14 percent. If CAPM holds, what should the return on the market and the

risk free rate be?

What are the importance of the cost breakdown of a bid items.