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 1.6 C 80 million 1.8 D 80 million 1.0 E 60 million 1.6

Kish's beta coefficient can be found as a weighted average of its stocks' betas. The risk-free rate is 6%, and you believe the following probability distribution for future market returns is realistic: Probability Market Return 0.1 -29% 0.2 0 0.4 13 0.2 28 0.1 49

What is the equation for the Security Market Line (SML)? (Hint: First determine the expected market return.) ri = 9.7% + (6.8%)bi ri = 9.7% + (7.1%)bi ri = 6.0% + (6.8%)bi ri = 9.8% + (7.0%)bi ri = 6.0% + (7.1%)bi

Calculate Kish's required rate of return. Do not round intermediate calculations. Round your answer to two decimal places. % 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 1.4. Should Kish invest in the new company? The new stock 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

Ans.

1. Market Return = 0.1 * -29% + 0.2* 0 + 0.4 *13% + 0.2 * 28% + 0.1 * 49% = 12.8%

a. Equation for the Security Market Line = Risk Free + Beta (Market return - risk free)

= Equation for the Security Market Line = 6% + Beta * ( 12.8 % - 6 % )

= Equation for the Security Market Line = 6% + Beta * 6.8% ( Option III is correct)

b. Kish's required rate of return = 6% + Beta * 6.8%

Beta calculation

Stock	Value	Beta	Weight	Weigheted Beta
A	$ 160.00	0.4	0.32	0.128
B	$ 120.00	1.6	0.24	0.384
C	$     80.00	1.8	0.16	0.288
D	$     80.00	1	0.16	0.16
E	$     60.00	1.6	0.12	0.192
	$ 500.00		1	1.152

Kish's required rate of return = 6% + 1.152 * 6.8% = 13.8336 % or 13.83%

c. Expected Return of new stock = 6% + Beta * 6.8%

Expected Return of new stock = 6% + 1.40 * 6.8% = 15.52%

As the expected return is higher than portfolio's expected return ,the new stock should be purchased

d. at 15.52% the kish will be at indifferent