Question

You plan to invest in the Kish Hedge Fund, which has total capital of $500 million invested in five stocks:

Stock	Investment	Stock's Beta Coefficient
A	$160 million	0.4
B	120 million	1.1
C	80 million	2.2
D	80 million	1.0
E	60 million	1.5

Kish's beta coefficient can be found as a weighted average of its stocks' betas. The risk-free rate is 3%, and you believe the following probability distribution for future market returns is realistic:

Probability	Market Return
0.1	-27%
0.2	0
0.4	12
0.2	32
0.1	45

1. What is the equation for the Security Market Line (SML)? (Hint: First determine the expected market return.)
   
   1. r_i = 3.0% + (10.0%)b_i
   2. r_i = 1.7% + (10.7%)b_i
   3. r_i = 3.0% + (10.9%)b_i
   4. r_i = 5.8% + (10.0%)b_i
   5. r_i = 5.8% + (10.9%)b_i
   
   -Select-IIIIIIIVVItem 1
   
2. Calculate Kish's required rate of return. Do not round intermediate calculations. Round your answer to two decimal places.
     %
   
3. Suppose Rick Kish, the president, receives a proposal from a company seeking new capital. The amount needed to take a position in the stock is $50 million, it has an expected return of 14%, and its estimated beta is 1.5. Should Kish invest in the new company?
   The new stock -Select-should notshouldItem 3 be purchased.
   
   At what expected rate of return should Kish be indifferent to purchasing the stock? Round your answer to two decimal places.
     %

Answer 1

Portfolio beta is equal to weighted average beta

= 0.4*160/500 + 1.1*120/500 + 2.2*80/500 + 1*80/500 + 1.5*60/500

= 1.084

Expected Market return = 0.1*-27% + 0.2*0% + 0.4*12% + 0.2*32% + 0.1*45%

= 13%

SML Equation is : Stock return = Risk free rate + beta*(Market return – risk free rate)

= 3% + b*(10%)

i.e. I

b.Required rate of return = 3% + 1.084*10%

= 13.84%

c.Rate of return required = 3% + 1.5*10%

= 18%

SHOULD NOT be purchased as return is lower

Indifference expected rate of return = 18%