Tuesday, March 20, 2007 Ch 8-2

1. Use the following information for problems 1-3. A stocks expected return has the following
distribution:
Demand for the
Companys Products
Weak
Below Average
Average
Above Average
Strong

Probability of this Demand

Occurring
0.1
0.2
0.4
0.2
0.1

1.
A.
B.
C.
D.

Calculate the stocks expected return.

10.45%
10.90%
11.40%
11.75%

2.
A.
B.
C.
D.

Calculate the standard deviation.

28.32%
27.53%
27.12%
26.69%

3.
A.
B.
C.
D.

Calculate the stocks coefficient of variation.

1.34
2.34
3.34
4.34

Rate of Return if this Demand

Occurs
-50%
-5%
16%
25%
60%

1. = (0.1)(-50%) + (0.2)(-5%) + (0.4)(16%) + (0.2)(25%) + (0.1)(60%)

= 11.40%.
2. s2 = (-50% 11.40%)2(0.1) + (-5% 11.40%)2(0.2) + (16% 11.40%)2(0.4)
+ (25% 11.40%)2(0.2) + (60% 11.40%)2(0.1)
s2 = 712.44; s = 26.69%.
3. CV = 2.34.
2. An individual has $35,000 invested in a stock with a beta of 0.8 and another $40,000
invested in a stock with a beta of 1.4. If these are the only two investments in her
portfolio, what is her portfolio risk?
Investment
Beta
$35,000
0.8
40,000
1.4
Total $75,000
bp = ($35,000/$75,000)(0.8) + ($40,000/$75,000)(1.4) = 1.12.

3. Assume that the risk-free rate is 6 percent and the expected return on the market is 13
percent. What is the required rate of return on a stock with a beta of 0.7?
rRF = 6%; rM = 13%; b = 0.7; r = ?
r = rRF + (rM rRF)b
= 6% + (13% 6%)0.7
= 10.9%.
4. Assume that the risk-free rate is 5 percent and the market risk premium is 6 percent.
What is the expected return for the overall stock market? What is the required return on a
stock with a beta of 1.2?
rRF = 5%; RPM = 6%; rM = ?
rM = 5% + (6%)1 = 11%.
r when b = 1.2 = ?
r = 5% + 6%(1.2) = 12.2%.
5. A stock has a required return of 11%; the risk-free rate is 7%; and the market risk
premium is 4%.
a. What is the stocks beta?
b. If the market risk premium increased to 6%, what would happen to the stocks required
rate of return? Assume that the risk-free rate and the beta remain unchanged
a. r = 11%; rRF = 7%; RPM = 4%.
r = rRF + (rM rRF)b
11% = 7% + 4%b
4% = 4%b
b = 1.
b. rRF = 7%; RPM = 6%; b = 1.
r = rRF + (rM rRF)b
= 7% + (6%)1
= 13%.
6. ERCI Corporation is a holding company with four main subsidiaries. The percentage
of its capital invested in each of the subsidiaries, and their respective betas, are as follows
Subsidiary
Percentage of Capital
Beta
Electric Utility
60%
0.70
Cable Company
25
0.90
Real Estate Development
10
1.30
International/special projects
5
1.50
a. What is the holding companys beta?
b. If the risk-free rate is 6% and the market risk premium is 5%, what is the holding
companys required rate of return?
a. b = (0.6 X 0.70) + (0.25 X 0.90) + (0.1 X 1.30) + (0.05 X 1.50)
beta = 0.85
b. rRF = 6%; RPm = 5%; b = 0.85
r = 6% + (5%)(0.85)
r = 10.25%

7. Calculate the required rate of return for Manning Enterprises, assuming that investors expect a
3.5% rate of inflation in the future. The real risk-free rate is 2.5% and the market risk premium is
6.5%. Manning has a beta of 1.7, and its realized rate of return has averaged 13.5% over the past
5 years.
rF = r* + IP = 2.5% + 3.5% = 6%

rs = 6% + (6.5%)1.7 = 17.05%.
The risk-free rate is compromised of 1. a real inflation-free rate, r*; and, 2. an inflation premium