PartTwo

ImportantConceptualTools
PartTwoIncludes
Chapter4

ReturnandRisk

Chapter5

ModernPortfolioConcepts

49Gitman/JoehnkFundamentalsofInvesting,NinthEdition

Chapter4
ReturnandRisk
.1

Outline

Learning Goals
I.

TheConceptofReturn
A) ComponentsofReturn
1. CurrentIncome
2. CapitalGains(orLosses)
B) WhyReturnIsImportant
1. HistoricalPerformance
2. ExpectedReturn
C) LevelofReturn
1. InternalCharacteristics
2. ExternalForces
D) HistoricalReturns
ConceptsinReview

II.

TheTimeValueofMoney
A) Interest:TheBasicReturntoSavers
1. SimpleInterest
2. CompoundInterest
B) ComputationalAidsfortheUseofTimeValueCalculations
1. FinancialCalculators
2. ComputersandSpreadsheets
C) FutureValue:AnExtensionofCompounding
D) FutureValueofanAnnuity
E) PresentValue:AnExtensionofFutureValue
F) ThePresentValueofaStreamofIncome
1. PresentValueofaMixedStream
2. PresentValueofanAnnuity
G) DeterminingaSatisfactoryInvestment

ConceptsinReview

51Gitman/JoehnkFundamentalsofInvesting,NinthEdition

III. MeasuringReturn
A) Real,RiskFree,andRequiredReturns
B) HoldingPeriodReturn
1. UnderstandingReturnComponents
2. ComputingtheHoldingPeriodReturn(HPR)
3. UsingtheHPRinInvestmentDecisions
C) Yield:TheInternalRateofReturn
1. YieldforaSingleCashFlow
2. YieldforaStreamofIncome
3. InterestonInterest:TheCriticalAssumption
D) FindingGrowthRates
ConceptsinReview
IV. Risk:TheOtherSideoftheCoin
A) SourcesofRisk
1. BusinessRisk
2. FinancialRisk
3. PurchasingPowerRisk
4. InterestRateRisk
5. LiquidityRisk
6. TaxRisk
7. MarketRisk
8. EventRisk
B) RiskofaSingleAsset
1. StandardDeviation:AnAbsoluteMeasureofRisk
2. CoefficientofVariation:ARelativeMeasureofRisk
3. HistoricalReturnsandRisk
C) AssessingRisk
1. RiskReturnCharacteristicsofAlternativeInvestmentVehicles
2. AnAcceptableLevelofRisk
3. StepsintheDecisionProcess:CombiningRiskandReturn
ConceptsinReview

Summary
PuttingYourInvestmentKnowHowtotheTest
DiscussionQuestions
Problems
CaseProblems
4.1. SolomonsDecision
4.2. TheRiskReturnTradeoff:MollyORourkesStockPurchaseDecision
ExcelwithSpreadsheets

Chapter4ReturnandRisk52

TradingOnlinewithOTIS

53Gitman/JoehnkFundamentalsofInvesting,NinthEdition

.2

Key Concepts

1.

Theconceptofreturn,itscomponentparts,andtheforcesthataffectthelevelofreturnrealizedbyan
investor.Historicalreturnsarereviewed.

2.

Interestincomeandtheconceptoftimevalue,itsunderlyingfutureandpresentvaluecomputations,
anditsuseintheinvestmentdecisionmakingprocess.

3.

Usageoffinancialcalculators,computers,andspreadsheetsinmeasuringriskandreturn.

4.

Real,riskfree,andrequiredreturnsoninvestments.

5.

Thecomputationanduseoftheholdingperiodreturnandtheinternalrateofreturn,andtheroleyield
canplayintheinvestmentdecision.

6.

Thesourcesandbasictypesofrisk,theconceptofrisk,itspositiverelationshiptoreturn,anditsrole
ininvestmentdecisionmaking.

7.

Thebasicstepsinvolvedinevaluatingtheriskreturncharacteristicsofaninvestment.

.3

Overview

Theconceptsofreturnandriskaredevelopedinthischapter.Thechapterisconceptuallymoredemanding
thantheprecedingone,sotheinstructorshouldplantospendmoreclasstimeonit.
1.

Returnsarerewardsforinvesting.Thecomponentsoftotalreturnarecurrentincomeandcapital
gains(orlosses).Currentincomeisincomereceivedincashornearcash,whereascapitalgains
referstoincomethatisattributedtoanincreaserealizedorunrealizedinthevalueofthe
investment.

2.

Expectedreturnmotivatesapersontoinvestinaparticularvehicle.Expectationsofreturnsarebased
onthepastreturnsofthatvehicle.Measuringthehistoricalreturnofaparticularinvestmentreveals
itsaveragereturnaswellasthetrendofitsreturns.Theinstructormaydemonstratethisbydiscussing
Table4.3inclass.

3.

Thelevelofreturnsforaparticularinvestmentvehicledependsoninternalcharacteristics,suchas
typeofinvestmentandissuercharacteristics,andexternalforces,suchaswar,politicalevents,and
thelevelofpricechanges(inflationordeflation).

4.

Thevitallyimportantconceptsofthetimevalueofmoney,futurevalue,andpresentvaluearecovered
next.Theseconceptsarebestexplainedbyworkingthroughafewexamplesthatdealwithsingle
sums,annuities,andmixedstreams.Theinstructorshouldemphasizethatpresentvaluecalculations
provideadollarvalue(intodaysterms)offuturecashflows.Thepresentvalueconceptisapowerful
toolthatmakesitpossibletocomputethedollarvalueofanyasset.Someassetsthatmightbe
profitablyconsideredinclassarestocks,bonds,otherfinancialassets,physicalassets(machines),
realestate,andevencompaniesthemselves.

5.

Asatisfactoryinvestmentisoneinwhichthepresentvalue(PV)ofbenefits(discountedatthe
appropriaterate)equalsorexceedsthePVofcosts.TheinstructormayindicatethatNPV(PVof
benefitsminusPVofcosts)measuresthesamething.

Chapter4ReturnandRisk54

6.

Therequiredreturnofaninvestmentistheratewhichcompensatestheinvestorforitsrisk.Itis
composedoftherealrateofreturnthereturnearnedinaperfectworldwithnoriskplusthe
expectedinflationpremium,whichiscalledtheriskfreerate,plustheriskpremiumforthe
investment.

7.

Theholdingperiodreturn(HPR),definednext,isusefulinmakinginvestmentdecisions.The
instructormayshowtheclasshowHPRiscomputedinTable4.11,stressingthattheHPRfrom
identicalperiodsshouldbeusedwhencomparingtwoinvestments.

8.

Yield,alsocalledtheinternalrateofreturn(IRR),representstheannualrateofreturnearnedona
longterminvestment.Asatisfactoryinvestmentisonethathasayieldequaltoorgreaterthanthe
appropriatediscountrate.Someinstructorsmaywanttospendtimediscussingthecriticalassumption
interestoninterestthatunderliesyield.Othersmaychoosetoskipthistechnical,butimportant,
discussion.ThosewhocoverinterestoninterestshouldfindFigure4.3helpfulinexplainingit.At
thispoint,theinstructorshouldhavemadeitcleartotheclassthatthereturnsfromaninvestment
maybemeasuredeitherindollarorpercentageterms.

9.

Thecalculationofgrowthratesforstreamsofdividendsorearnings,apresentvalueapplicationthat
isanimportantpartofcommonstockvaluation,iscoverednext.

10. Theconceptofriskisnextintroducedanddefined.Thepossiblesourcesofriskincludebusinessrisk,
financialrisk,purchasingpowerrisk,interestraterisk,liquidityrisk,taxrisk,marketrisk,andevent
risk.Thebasictypesofriskincludediversifiable,nondiversifiable,andtotal.Nextintroducedisthe
riskofasingleasset,thestandarddeviationasameasureofabsoluterisk,andthecoefficientof
variationasarelativemeasureofrisk.Theriskreturntradeoffisalsodiscussed.
11. Thetextsdescriptionofthefourstepsintheinvestmentprocessareusefulandshouldbe
highlighted.

.4

Answers to Concepts in Review

1.

Thereturnoninvestmentistheexpectedprofitthatmotivatespeopletoinvest.Itincludesboth
currentincomeand/orcapitalgains(orlosses).Withoutapositiveexpectedreturn,thereisnobenefit
toinvestingandindividualshavenoreasontosaveandinvest.Sincenetdemandersarewillingtopay
netsaversapositivereturnfortheirfunds,theopportunitytoearnapositivereturnexists.
Returnoninvestmentcancomefromeithercurrentincomeorcapitalgains,orboth.Currentincome,
mostcommonly,isperiodicpayments,suchasinterestreceivedonbonds,dividendsonstock,orrent
receivedfromrealestate.Tobeconsideredincome,thesepaymentsmustbereceivedincashorbe
readilyconvertibletocash.Capitalgainreferstothechangeinthemarketvalueoftheinvestment.
Theamountbywhichtheproceedsfromthesaleofaninvestmentexceedtheoriginalpurchaseis
calledacapitalgain.Ifitissoldforlessthantheoriginalpurchaseprice,acapitallossisrealized.
Theuseofpercentagereturnsisgenerallypreferredtodollarreturnstoallowinvestorstodirectly
comparedifferentsizesandtypesofinvestments.

2.

Althoughfuturereturnsarenotguaranteedbypastperformance,historicaldataoftengivesthe
investorameaningfulbasisonwhichtoformfutureexpectations.Pastreturndata,suchasaverage
returnsortrendsseenincertaintimeperiods,canbeusedalongwiththeinvestorsinsightsabout
futureprospectsoftheinvestment.Togetherthehistoricaldataandfutureprospectshelptheinvestor
toformulateanexpectedreturnontheinvestment.

55Gitman/JoehnkFundamentalsofInvesting,NinthEdition

Thelevelofexpectedreturnsdependsonmanyinternalcharacteristicsoftheinvestmentandthe
externalforcesontheinvestment.Internalcharacteristicsincludethetypeofinvestment,thequality
ofmanagement,themethodbywhichtheinvestmentisfinanced,andthecustomerbaseoftheissuer.
Externalforcesincludewar,shortages,pricecontrols,FederalReserveactions,andpoliticalevents,
amongothers.Externalforces,unlikeinternalcharacteristics,cannotbecontrolledbytheissuerofthe
investment.Investmentvehiclesareaffecteddifferentlybytheseforcestheexpectedreturnofone
investmentmayincreasewhiletheexpectedreturnofanothermaydecreaseinresponsetoexternal
forces.
Historytellsusthatstockmarketreturnshaveaveragedwellabovetheinterestratespayableon
savingsaccountsatbanks. Inrecentyearsespeciallyduringthelatterpartofthe1990sthereturns
werewellabovethestockmarketaveragesfortheearlierpartofthecentury.Unfortunately,the
articledoesnotprovideaclearmessageforinvestorsotherthanhistorycanrepeatitself.Ifthe
investorislookingforshorttermgainsoverayearortwo,theprobabilitiesaremixeddependingon
whattimeperiodsarecited.Thebestadvice,giventhesestatistics,istoinvesttoholdforthelong
terminordertorideoutthemarketstwistsandturns.
3.

Timevalueofmoneyreferstothefactthat,withtheopportunitytoearninterestonfunds,thevalueof
moneydependsonthepointintimewhenthemoneyisexpectedtobereceived.Thus,thesoonerone
receivesmoneythebetterthemorevaluableisthatmoney.
Becausemoneyhastimevalue,peoplewillingtoinvesttheirmoneyshouldbeabletoearnapositive
return.Forexample,aninvestorexpectingtoreceivea$100interestpaymentfor2different
securitiesdoesntnecessarilyvaluethemequally.Ifthefirstinvestmentpaystheinterestattheendof
oneyear,butthesecondinvestmentpaystheinterestattheendoftwoyears,thefirstinvestmentwill
bemorevaluable.The$100canbereinvestedtoearninterestforanentireyear.AttheendofYear2,
thefirstinvestmenthasreturned$100interest,thesecondhasreturned$100totheinvestor.The
$100reinvestmenthasearnedapositivereturn;theother$100hasnothadachancetoaccumulate
interest.

4.

(a) Interestisthecurrentincomeyoureceivefromplacingavailablefundsinasavingsaccount,CD,
bond,orbymakingaloan.Itisineffecttherentpaidonyourmoneybythosewhoobtainuse
ofit.
(b) Simpleinterestisinterestpaid(earned)onlyontheinitialbalancefortheactualamountoftimeit
isondeposit.Withsimpleinterest,thestatedinterestrateisalwaysequaltothetruerateof
interest(orreturn).
(c) Compoundinterestisinterestpaidnotonlyontheinitialdepositbutalsooninterestaccumulated
fromoneperiodtothenext.Thisisthemethodsavingsinstitutionsgenerallyemploy.When
interestiscompoundedannually,thesimple,compound,andtrueratesofinterestarethesame.
(d) Thetruerateofinterest(orreturn)takestheconceptofcompoundingintoaccount.When
interestiscompoundedannually,thestatedandtrueinterestratesareequal.Formorefrequent
compounding,thetruerateofinterestwouldbehigherthanthestatedrate.HenceanAPRof
15%onacreditcardwhichiscompoundeddailyhasatrueinterestrateof16.18%.

5.

Thetruerateofinterestrisesasinterestiscompoundedmorefrequentlythanannually.Thetrueand
statedratesarethesamewheninterestiscompoundedannually.Continuouscompoundingoccurs
wheninterestiscompoundedoverthesmallestpossibletimeperiod.

Chapter4ReturnandRisk56

6.

Thefuturevalueofacashflowrepresentstheamounttowhichacurrentdepositwillgrowovera
giventimeperiodifitisplacedinanaccountpayingcompoundinterest.Presentvalueisconcerned
withfindingthecurrentvalueofafuturesum,giventhattheinvestorearnsastatedreturnthe
discountrate(oropportunitycost)onsimilarinvestments.Thediscountrateistherateatwhich
futuresumsarediscountedtofindtheirpresentvalues.Thepresentvalueconceptistheinverseofthe
futurevalueconcept.

7.

Anannuityisastreamofequalcashflowsthatoccurinequalintervalsovertime.Thesecashflows
canbepaidoutorreceived.Anordinaryannuityhascashflowsoccurattheendofeachyear.To
simplifythecalculationofthefuturevalueofanannuity,onecanusethefuturevalueinterestfactor
oftheannuitytableincludedinAppendixA,TableA.2.Thepresentvalueofanannuitycanbefound
similarlyinthepresentvalueinterestfactoroftheannuitytableinAppendixA,TableA.4.
CalculatorsarealsodesignedwithannuityPMTkeys.

8.

Amixedstreamofreturnsisaseriesofreturnsthatexhibitsnopattern.Tofindthepresentvalueofa
mixedstream,calculatethepresentvalueofeachcomponentofthemixedstream.Thesummationof
thepresentvalueofindividualcomponentsgivesusthepresentvalueoftheentiremixedstream.

9.

Ignoringrisk,asatisfactoryinvestmentisoneforwhichthepresentvalueofbenefits(discounted)
equalsorexceedsthepresentvalueofcosts.Ifthepresentvalueofbenefitsexceedsthecost,the
investorwouldearnmorethanthediscountratei.e.thereturnontheinvestmentisgreaterthanthe
discountrate.

10. (a) Therealrateofreturnisthereturnearnedinacertain,riskfreeworld.Itwouldequalthe

nominalrateofreturnonariskfreesecuritylessinflation.Historically,ithasbeenrelatively
stableintherangeof0.5to2%.
(b) Theexpectedinflationpremiumrepresentstheexpectedaveragefuturerateofinflation.Itisthe
compensationthatinvestorsdemandforfutureexpectedinflation;thatis,thedeclineinthe
purchasingpowerofthedollar.
(c) Theriskpremiumvariesfordifferentsecurityissuesandrepresentstheadditionalreturnrequired
tocompensateaninvestorfortheriskcharacteristicsoftheissueandtheissuer.Itisthereturnon
arisksecurity(e.g.stocks,bonds)minustheriskfreerateofreturn,whichistherateona90day
TBill.
Theriskfreerateofreturnequalstherealrateofreturnplustheexpectedinflationpremium:
RFr*IP.Itisthereturnonarisklesssecurityasmeasuredbythe90dayTBill.
Therequiredrateofreturnequalstherealrateofreturnplustheexpectedinflationpremium
(together,theriskfreerate)andtheriskpremium:riRFIP.Alternatively,itequalstherisk
freerateofreturnplustheriskpremium.
11. Theholdingperiodissimplytheperiodoftimeoverwhichtheinvestorwishestomeasurethereturn
onaninvestment.Incomparingalternativeinvestmentvehicles,itisessentialtouseequallength
holdingperiodssothatthetwovehiclesbeingcomparedarejudgedunderidenticalconditions.This
addsobjectivitytothecomparison.Mostinterestratesarequotedonanannualbasis,soitisgenerally
convenienttouseaoneyearholdingperiod.
Theholdingperiodreturn(HPR)isthetotalreturnearnedfromholdinganinvestmentforaspecified
periodoftime.TocalculateHPR,allthatisneededisthebeginningandendofperiodinvestment
valuesalongwiththevalueofcurrentincomereceivedbytheinvestor.BecauseHPRdoesntaccount
forthetimevalueofmoney,theholdingperiodisusuallyoneyearorless.

57Gitman/JoehnkFundamentalsofInvesting,NinthEdition

12. Theyield,orIRR,istheannualrateofreturnearnedbyalongterminvestment.Itisalsodefinedas
thediscountratethatproducesapresentvalueofbenefitsreceivedequaltothepresentvalueof
costs/investments.UnliketheHPR,ittakesintoaccountthetimevalueofmoneyandcanbeusedto
calculatethereturnoninvestmentsheldforoveroneyear.TheHPRisinappropriateforinvestments
heldformorethanoneyear.
13. Thecriticalassumptionunderlyingtheuseofyieldasareturnmeasureisanabilitytoearnareturn
equaltothecalculatedyieldonallincomereceivedfromtheinvestmentduringtheholdingperiod.If
youearn10percentonallincomereceivedfromaninvestmentduringtheholdingperiod,youryield
ontheinvestmentwillbe10percent.Ontheotherhand,ifyouearn0percentontheincomereceived,
yourrateofreturnontheinvestmentwouldactuallybelessthan10percent.Iftheintereston
interestearnedfromtheinvestmentislessthanitscalculatedyield,theinvestmentsreturnwillfall
belowtheyield.Clearlywhenusingyieldasameasureofinvestmentreturn,thevalidityofthis
assumptionmustberecognizedandevaluated.Iftheinterestoninterestassumptiondoesnothold,
useofthecalculatedyieldcouldleadtopoorinvestmentdecisions.(Note:Theinstructormaywantto
usethediscussionofinterestoninterestandFigure4.3todemonstratethissomewhatcomplex,but
extremelyimportant,yieldconcept.)
14. Ifthepresentvalueofreturnsfromaninvestmentisgreaterthantheinitialcostoftheinvestment,it
isasatisfactoryinvestmentandshouldbeacceptable.Iftheyieldfromaninvestmentisgreaterthan
theappropriatediscountrateforthatinvestment,thepresentvalueandyieldprovidethesame
conclusionregardingacceptability.
Intheexamplegiven,InvestmentAisclearlyacceptablesinceitsyield(8percent)isgreaterthanthe
appropriatediscountrate(7percent).InvestmentB,ontheotherhand,isnotacceptablesinceits
presentvalueofreturns($150)is$10lessthanitscost($160).InvestmentCisnotacceptablesince
itsyield(8percent)islowerthantheappropriatediscountrate(9percent).
15. Riskisthechancethattheactualreturnfromaninvestmentmaydifferfromwhatisexpected.The
standarddeviationisthestatisticusedtomeasurerisk.Theriskreturntradeoffistherelationship
betweentheexpectedreturnsfromaninvestmentandtheriskassociatedwiththem.Therequired
returnsfromaninvestmentincreaseasriskincreasestoprovideanincentiveforhimorhertotake
higherrisksi.e.inordertoaccepthigherrisks,theinvestorshavetobecompensatedwithhigher
returns.
16. (a) Businessriskisconcernedwiththedegreeofuncertaintyassociatedwithaninvestments
earningsandtheinvestmentsabilitytopayinvestorsinterest,dividends,andotherreturnsowed
them.Businessriskisusuallyrelatedtothefirmslineofbusiness.
(b) Financialriskistheriskassociatedwiththemixofdebtandequity(capitalstructure)usedto
financethefirm.Thegreaterthefirmsdebtsandinterestobligations,thegreateritsfinancial
risk.
(c) Purchasingpowerriskarisesbecauseofuncertaininflationratesandpricelevelchangesinthe
future.Whenpricesrise,eachdollarinvestedhaslessvalueitcanbuyless,andviceversa.
(d) Interestrateriskisriskassociatedwithchangesinthepricesoffixedincomesecuritiesresulting
fromchangingmarketinterestrates.Asthemarketinterestrateschange,thepricesofthese
securitieschangeintheoppositedirection,therebychangingthelevelofreturnthataninvestor
canexpecttoobtainfromthem.Anotherimportantaspectofinterestrateriskinvolvestheability
toreinvestincomereceivedattheinitialrateofreturninordertoearnthefullycompoundedrate
ofreturn.

Chapter4ReturnandRisk58

(e) Liquidityriskistheriskofnotbeingabletoliquidateaninvestmentconvenientlyandata
reasonableprice.Ingeneral,investmentvehiclestradedinmarketswithsmalldemandand
supplycharacteristicstendtobelessliquidthanthosetradedinbroadmarkets.
(f) TaxriskistheriskthattaxlawsenactedbyCongresswilladverselyaffectcertaintypesof
investmentsanddecreasetheiraftertaxreturns.

59Gitman/JoehnkFundamentalsofInvesting,NinthEdition

(g) Marketriskistheriskofchangesininvestmentreturnscausedbyfactorsindependentofthe
giveninvestmentvehicle.Itresultsfromfactorssuchaspolitical,economic,andsocialevents,or
changesininvestortastesandpreferences.
(h) Eventriskistheriskthatcomesfromalargelyortotallyunexpectedeventwhichhasa
significantandusuallyimmediateeffectontheunderlyingvalueofaninvestment.Theeffectof
thisriskseemstobeisolatedinmostcases,affectingonlycertaincompaniesandproperties.
17. Standarddeviationisthemostcommonmeasureofanassetsrisk.Itmeasuresthedispersionof
returnsaroundanassetsaverageorexpectedreturn.Standarddeviationisanabsolutemeasureof
risk,andthuscanbeusedtocomparetheriskinessofcompetinginvestmentswiththesameexpected
return.Thecoefficientofvariation(CV)measurestherelativedispersionofanassetsaverageor
expectedreturns.Likestandarddeviation,thehighertheCV,thehighertherisk.CVdiffersfrom
standarddeviationbecauseitisarelativemeasureofriskandcanbeusedtocomparetheriskinessof
competinginvestmentswithdifferentexpectedreturns.
18. Investorsattitudestowardriskortheirriskreturntradeoffsmaybeclassifiedasoneofthefollowing:
Riskindifferentinvestorsdonotrequireagreaterreturninexchangeforeachunitofadditionalrisk.
Riskaverseinvestorsrequiregreaterreturninexchangeforeachunitofadditionalrisk.Thetradeoff
hereispositive;returnmustincreaseasriskincreases.
Risktakinginvestorsacceptalowerreturninexchangeforgreaterrisk.Thistradeoffisnegative;
suchinvestorsenjoyriskandarethereforewillingtoacceptlowerreturnsforincreasinglevelsof
risk.
Ingeneral,mostinvestorsareriskaverse.Theyrequireincreasedreturnsfromaninvestmentasits
riskincreases.Theriskpreferenceofaninvestorisanimportantdeterminantofhis/herinvestment
decisions.Riskaverseinvestorsmaynotmakespeculativeinvestments,whilerisktakinginvestors
may.Thus,aninvestmentthatisconsideredunsatisfactorybyariskaverseinvestormaybedeemed
satisfactorybyarisktakinginvestor.
19. Theinvestmentprocesscanbesummarizedinfoursteps:
(1) Estimatetheexpectedreturnoveragivenholdingperiodusinghistoricaldataorprojectedreturn
data,orboth.Thetimevalueofthesereturnsmustbeconsideredforlongterminvestments.
(2) Assesstheriskoftheinvestmentreturnsthroughthesubjective(judgmental)evaluationof
historicalreturnsandbyusingbeta(forsecurities).
(3) Evaluatetheriskreturnbehaviorofeachalternativeinvestment.Theexpectedreturnmustbe
reasonablegiventhelevelofriskpossessedbytheinvestment.Onlyinvestmentsofferingthe
highestexpectedreturnforagivenlevelofriskareconsideredreasonable.
(4) Selectthevehicleswiththehighestreturnforthelevelofrisktheinvestoriswillingtotake.
Thesefitthedefinitionofagoodinvestment.

Chapter4ReturnandRisk60

.5

61Gitman/JoehnkFundamentalsofInvesting,NinthEdition

.6

Suggested Answers to Discussion Questions

Answerswillvaryaccordingtostudentsselections,tastes,andpreferences.

.7

Solutions to Problems

1.

Theinvestorwouldearn$8.25onastockthatpaid$3.75incurrentincomeandsoldfor$67.50.Part
ofthetotaldollarreturnincludesa$4.50capitalgainwhichisthedifferencebetweentheproceedsof
thesaleandtheoriginalpurchaseprice($67.50$63.00)ofthestock.

2.

Theinvestorhadinterestincomeof$900(threepaymentsof$300each),andacapitallossof$500.

3.

(a) Currentincome:

$2.70

(b) Capitalgain:$60$50
$10
(c) Totalreturn:
(1) Indollars:$2.70$10.00
$12.70
(2) Asapercentageoftheinitialinvestment: $12.700.25or25%.
50.00
4.

(a) Currentincomeistheinterestincome,whichisequalto$900(threepaymentsof$300).
(b) Capitalgainis$10,000$9,500$500
(c) Totalreturn$900$500$1,400.$1,400/$9,50014.7%.

5.

(a) TotalreturnCurrentincomeCapitalgains(orlosses)where:
Capitalgains(orlosses)EndingpriceBeginningprice
(1)
Year
2001
2002
2003
2004
2005

Ending
Price
$32.50
35.00
33.00
40.00
45.00

(2)

Beginning
Price
$30.00
32.50
35.00
33.00
40.00

(3)
(1)(2)
Capital
Gain
$2.50
2.50
2.00
7.00
5.00

(4)

Current
Income
$1.00
1.20
1.30
1.60
1.75

(5)
(3)(4)
Total
Return
$3.50
3.70
0.70
8.60
6.75

(b) Ofcourse,thereisnocorrectanswerhere,butonemightforecastusingthearithmeticaverageor
theaverageoneyearholdingperiodreturn.
$3.50 $3.70 $0.70 $8.60 $6.75
(i) Thearithmeticaverage:
$4.37
5
(ii) Theaverageholdingperiodreturn(HPR):
HPR

Endingprice Beginningprice Currentincome

TotalReturn

Beginningprice
BeginningPrice

Chapter4ReturnandRisk62

Year
2001
2002
2003
2004
2005

(1)
Total
Return*
$3.50
3.70
0.70
8.60
6.75

(2)
Beginning
Price
$30.00
32.50
35.00
33.00
40.00

(3)
(1)(2)
HPR
11.7%
11.4
2.0
26.1
16.9

*Frompart(a)inthepreviouspage.

AverageHPR

11.7 11.4 2.0 26.1 16.9

12.8%
5

(b)
(i)
Forecasts
for:
2006
2007

(ii)
Basedon
ArithmeticAverage
$4.37
$4.37

Basedon
AverageHPR
($45.00)*0.128$5.76
($49.00)**0.128$6.27

*Endof2005pricegaininoriginaldata.
**Forlackofinformation,weareassumingthe2006returnis$4.00fromcapital
gainsand$1.76fromcurrentincome.

(c) Studentsshouldbemadeawareofthefactthatmanyotherforecastsarepossible.Otherfactors
mayberelevanthere:Willthepatternoftwogoodyearsfollowedbyabadonecontinue?Do
futureprospectsseembright?(Wewilldiscussforecastingreturnsonspecificinvestment
vehiclesinlaterchapters.)
6.

Totalreturncurrentincomepluscapitalgains.
Currentincome100($1$1.2$1.3)$350.
Capitalgain$100($33$30)$300.00.
Totalreturn$350$300$650.
Asapercentoftheoriginalinvestment:$650/(100$30$3,000)21.7%.

63Gitman/JoehnkFundamentalsofInvesting,NinthEdition

8.

(a) Futurevalueof$300intwelveyearsat7percentannualcompoundinterest:
Futurevalue presentvalue (futurevalueinterestfactor)
$300 (FVIF,12years,7%)
$300 (2.252)*
$675.60
*FromTableA.1,AppendixA.
(b) Thefuturevalueattheendof6yearsofan$800annualendofyeardepositat7%interest:
Futurevalue deposit (futurevalueinterestfactorforanannuity)
FV $800 (FVIF,6years,7%)
$800 (7.153)*
$5, 722.40
*FromTableA.2,AppendixA.

Note:Forsimplicity,theproblemsintherestofthechapterusetheabbreviationsFV,FVIF,FVIFA,PV,
PVIF,PVIFA,andk(interestrate/rateofreturn),n(numberofyears/investmentperiod).
9.

FutureValueofanInvestment:FVnInvestmentAmount(FVIFk,n)
A

Investment
FV20PVFVIF5%,20yrs.
FV20$2002.653
FV20$530.60
Calculatorsolution:$530.66

FV7PVFVIF8%,7yrs.
FV7$4,5001.714
FV7$7,713
Calculatorsolution:$7,712.21

FV10PVFVIF9%,10yrs.
FV10$10,0002.367
FV10$23,670
Calculatorsolution:$23,673.64

FV12PVFVIF10%,12yrs.
FV12$25,0003.138
FV12$78,450
Calculatorsolution:$78,460.71

FV5PVFVIF11%,5yrs.
FV5$37,0001.685
FV5$62,345
Calculatorsolution:$62,347.15

10. Thisisafuturevalueequation.Calculatethefuturevalueof$10,000usingaFVIF 1%,24periodsvalue.

$10,0001.270$12,700.

Chapter4ReturnandRisk64

11. FutureValueofanAnnuityInvestment:FVAk,nAnnualDepositFVIFAk,n
A

Investment
FVA8%,10yrs. $2,50014.487
$36,217.50
Calc.Soln. $36,216.41

FVA12%,6yrs. $5008.115
$4,057.50
Calc.Soln. $4,057.59

FVA20%,5yrs. $1,0007.442
$7,442
Calc.Soln. $7,441.60

FVA6%,8yrs. $12,0009.897
$118,764
Calc.Soln. $118,769.61

FVA14%,30yrs. $4,000356.778
$1,427,112
Calc.Soln. $1,427,147.39

(FVIFAfromAppendixA,TableA.2)

12. Futurevalueofanannuityof$1,000forfiveyearsat6%.$1,0005.637$56,370.
13. Theleastyouwouldacceptforeachinvestmentisitsfuturevalueattheendofsixyears:
(a) FutureValueofanInvestment:FVnInvestmentAmount(FVIFk,n)
FV9%,6yrs $5, 000 1.677
$8,385
Calc.Soln$8,385.50
(b) FutureValueofanAnnuityInvestment:
FVA k,n AnnualDeposit FVIFA k,n
FVA 9%,6yrs. $2, 000 7.523
$15, 046
Calc.Soln.$15,046.67
(c) FVof$3,000at9%for6yearsFVAof$1,000depositat9%atendofeachofthenextfive
years:
(1) FV9%,6yrs.
$3,0001.677(FromApp.A,TableA.1)
$5,031
Calc.Soln $5,031.30
(2) FVA9%,6yrs. $1,0007.523(FromApp.A,TableA.2)
$7,523
Calc.Soln. $7,523.33
(3) Total
$5,031$7,523
$12,554

65Gitman/JoehnkFundamentalsofInvesting,NinthEdition

(d)

Year
1
3
5

Number
ofYears
toCompound
5
3
1

EndofYear
Deposit
$900
900
900

Future
FVIF,9%
Value
1.539
$1,385.10
1.295
1,165.50
1.090
981.00
TotalFV$3,531.60

14. PresentValue:PVFVn(PVIFk,n)
Investment
A
B
C
D
E

FVPVIF
PV12%,4yrs.*$7,000.636
PV8%,20yrs.*$28,000.215
PV14%,12yrs.*$10,000
.208
PV11%,6yrs.$150,000
.535
PV20%,8yrs$45,000.233

Present
Value
$4,452
$6,020
$2,080

Calculator
Solution
$4,448.63
$6,007.35
$2,075.59

$80,250

$80,196.13

$10,485

$10,465.56

PVIFfromTableA.3,AppendixA.

15. Thisproblemusespresentvaluetosolveaninvestmentproblem.Theamountatwhichthebondwill
selltodayisthevaluetodayofitsvalueatmaturity(ineightyears),givenaninterestrateof6%:
PV FV (PVIFk,n )
PV6%,8yrs. $1, 000 0.627
$627(CalculatorSolution $627.41)
16. Youaretryingtofindthepresentvalueof$1,000in8yearsusingan8%discountrate.PVIF8%,8periods
$10000.540$1000$540.Thepriceofthebondislowerat8%.Thisisbecauseitisdiscountedat
ahigherrate(8%vs.6%).
17. Thisisapresentvaluequestion.Calculatethepresentvalueof$10,000usingaPVIF 3%,10periodsvalue.
$10,0000.744$7,440.

Chapter4ReturnandRisk66

18.
Income
Stream
A

Endof
Year
1
2
3
4
5

IncomePVIF,12%
$2,2000.893
3,0000.797
4,0000.712
6,0000.636
8,000.567

Calculatorsolution
B

1
25
6

$10,0000.893
5,0002.712*
7,000.507

Calculatorsolution
C

15
610

$10,0003.605**
8,0002.045***

CalculatorSolution

Present
Value
$1,965
2,391
2,848
3,816
4,536
$15,556
$15,555.51
$8,930
13,560
3,549
$26,039
$26,034.59
$36,050
16,360
$52,410
$52,411.34

*SumofPVfactorsforyears25.
PVIFfromTableA.3,AppendixA.
**PVIFAfor12%,5years
***(PVIFAfor12%,10years)(PVIFAfor12%,5years)
PVIFAfromTableA.4,AppendixA.

19. (a)
Income
Stream
A

Endof
Year
1
2
3
4

IncomePVIF,15%
$4,0000.870
3,0000.756
2,0000.658
1,0000.572

Calculatorsolution
B

1
2
3
4

$1,0000.870
2,0000.756
3,0000.658
4,0000.572

Calculatorsolution

Present
Value
$3,480
2,268
1,316
572

$7,636
$7,633.48
$870
1,512
1,974
2,288

$6,644
$6,641.41

PVIFfromTableA.3,AppendixA.

(b) IncomeStreamA,withapresentvalueof$7,636,ishigherthanIncomeStreamBspresentvalue
of$6.644becausethelargercashinflowsoccurinAintheearlyyearswhentheirpresentvalueis
greater.Thesmallercashflowsarereceivedfurtherinthefuture.

67Gitman/JoehnkFundamentalsofInvesting,NinthEdition

20. Thepresentvalueofaninvestmentwithannualincomestreamsiscalculatedusingtheformula:PVAn
Annualreturns(PVIFAk,n)
Investment
A
B

PVA7%,3yrs.
PVA12%,15

Calculation
$1,2002.624
5,5006.811

PresentValue
$3,148.80
37,460.50

Calc.Soln
$3,149.18
37,459.75

yrs

PVA20%,9

7004.031

2,821.70

2,821.68

14,0005.786
2,2003.791

81,004.00
8,340.20

81,009.23
8,339.73

yrs.

D
E

PVA5%,7yrs.
PVA10%,5yrs

21. Findthepresentvalueoftheannuityandcompareittothelumpsumpayment.PVIVA 8%,20periods

$1,000,0009.818$9,818,000.Sincethisislessthan$15million,youshouldtakethe$15million
today.
22. (a) Presentvalueof$500tobereceivedinfouryearsatan11percentdiscountrate:
PV FV PVIF11%,4yrs.
$500 0.659
$329.50
PVIFfromTableA.3,AppendixA.
(b) ThepresentvalueoftheincomefromStreamAisthepresentvalueofanannuity.
PVA Annualincome PVIFA 9%,7yrs.
PVAStreamA $80 (5.033)
$402.64
PVIFAfromTableA.4,AppendixA.
Thepresentvalueatthestartof2006oftheincomefromStreamBisthepresentvalueofa
mixedstreamthepresentvalueofeachbenefitsummed.

Year
2006
2007
2008
2009
2010
2011
2012

(1)

(2)

Benefit
$140
120
100
80
60
40
20

PVIF,9%
0.917
0.842
0.772
0.708
0.650
0.596
0.547
Total

(3)
(1)(2)
PresentValue
$128.38
101.04
77.20
56.64
39.00
23.84
10.94
$437.04

PVIFfromTableA.3,AppendixA.

Note:Thesestreamsmaybeusedtoillustratethetimevalueofmoney.Bothstreamshave$560intotal
benefits,butthebenefitsinStreamAarepresentlyworth$402.64,whilethebenefitsinStreamBare
worth$437.04.ThedifferenceisattributabletothefactthatStreamBhaslargerbenefitsorcashflows
earlier,therebycausingitspresentvalueatthe9percentratetobehigherthanStreamA.

Chapter4ReturnandRisk68

23. TheanalysisofTerrisinvestmentopportunitiesusestheformula:
FVnPV(FVIFk,n)
Investment
A

Calculation
$30,000$18,000FVIFk,5yrs.
$30, 000
FVIFk,5yrs.
$18, 000
1.667FVIFk,5yrs.
10%<k<11%

Decision

Invest

$3,000$600FVIFk,20yrs.
$3, 000
FVIFk,20yrs.
$600
5FVIFk,20
8%<k<9%

Forgo

$10,000$3,500FVIFk,10yrs.
$10, 000
FVIFk,10yrs.
$3, 500
2.857FVIFk,10yrs.
11%<k<12%

Invest

$15,000$1,000FVIFk,40yrs.
$15, 000
FVIFk,40yrs.
$1, 000
15FVIFk,40yrs.
7%<k<8%

Forgo

69Gitman/JoehnkFundamentalsofInvesting,NinthEdition

Analternativeapproachaccuratelyansweringthesamequestionswouldbethecalculationofthe
presentvalueofcashinflowsandcomparingtheresultstotheinvestmentscost.
InvestmentA
$30,0000.621$18,630(usingPVIF10%,5years)
CostofInvestment$18,000
ReturnexceedscostInvest
InvestmentB
$3,0000.149$447(usingPVIF10%,20years)
CostofInvestment$600
Costexceedsreturnforgo
InvestmentC
$10,0000.386$3,860(usingPVIF10%,10years)
CostofInvestment$3,500
ReturnexceedscostInvest
InvestmentD
$15,0000.022$330(usingPVIF10%,40years)
CostofInvestment$18,000
Costexceedsreturnforgo
24.
Income
Stream
A

Endof
Year
1
2
3
4
5

1
2
3
4
5

IncomePVIF,17%,n
$2,5000.855

3,5000.731

4,5000.624

5,0000.534

5,5000.456

TotalPV
Calculatorsolution

Present
Value
$2,137.50
2,558.50
2,808.00
2,670.00
2,508.00
$12,682.00
$12,680.08

$4,0000.855

3,5000.731

3,0000.624

1,0000.534

5000.456

TotalPV
Calculatorsolution

$3,420.00
2,558.50
1,872.00
534.00
228.00
$8,612.50
$8,610.42

PVIFfromTableA.3,AppendixA.

Chapter4ReturnandRisk70

At17%requiredreturn,thepresentvalueoftheincomefromInvestmentA,$12,682,islessthan
the$13,000purchaseprice.InvestmentBspresentvalueis$8,612.50,abovethepurchaseprice.
Therefore,KentshouldpurchaseInvestmentB.
25. $15,000PVIFA1%,50payments
$15,00039.196
$15,000/39.196$382.69
26. Balanceisthepresentvalueofthepaymentsat12%.Paymentsare$382.69PVIFA1%,40periods$382.69
32.835$382.69$12,565.62
27. (a) Usingthenotationgiveninthechapter,theriskfreerateofinterestforbothInvestmentsis:
R r * IP
3% 5%
8%
(b) Therequiredreturnsforeachinvestmentarecalculatedasfollows:
r1 r*IPRPi
rA 3%5%3%
11%
rB 3%5%5%
13%

or

RFRPi
8%3%
8%5%

28. Theriskfreeraterealrateexpectedinflationpremium.Iftheexpectedinflationpremium
increasesby1%,thentheriskfreeratewillincreaseby1%to8%.

71Gitman/JoehnkFundamentalsofInvesting,NinthEdition

29. Holdingperiodreturn(HPR)

Currentincome Endingprice Beginningprice

Beginningprice

$1.00 $1.20 $0 $2.30 $29.00 $30.00 $3.50

$30.00
$30.00
11.67%
$0 $0 $0 $2.00 $56.00 $50.00 $8.00
HPR Y

50.00
$50.00
16.0%

HPR X

Iftheinvestmentsareheldbeyondayear,thecapitalgain(loss)componentwouldnotberealizedand
wouldlikelychange.Assumingtheyareofequalrisk,InvestmentYwouldbepreferredsinceitoffers
thehigherreturn(16.0%forYversus11.67%forX).
30. HPR(currentincomeovertheperiodcapitalgains)/beginninginvestmentvalue
Firstinvestment:($1.002.00)/$2512%.Sincethisisasixmonthinvestment,theannualized
returnistwotimestheHPR(12/6),or24%.
Secondinvestment:($2.40$3.00)/$2720%.
Thefirstinvestmentprovidesthehigherannualizedreturn.
31. HPR($50($1,000$950))/$950$100/$95010.5%
32. Thepresentvalueis$5,000.Thevaluein10yearswillbe$9,000.
(a) Usingpresentvalue,theyieldiscalculatedas:
$9, 000 PVIFx%,10yrs. $5, 000
$5, 000
$9, 000
0.556

PVIFx%,10yrs.

FromTableA.3,AppendixA,at10yearsthePVIFof6%is0.558,whichisverycloseto0.556.
Theyield,then,isestimatedtobe6%.
(b) Ifaminimumreturnof9%isrequired,thisinvestmentwouldnotberecommendedbecauseit
onlyyieldsabout6%.
33. UsingPFIVof4%:
$650.962$62.53
$700.925$64.75
$700.889$62.23
$7,9650.855$6,810.08
$6,999.59

Chapter4ReturnandRisk72

34. Interestontheinvestmentinyearfive
(10,000FVIF8%,5years)$10,000($10,0001.469)$10,000$4,690
Yield:
$10,000(PVIF?%,5years$4690)(PVIF?%,6years$14,500)
Using12%:
(0.567$4690)(0.507$14,500)$2,659.23$7,351.50$10,010.73
Sincethistotaliscloseto$10,000,theyieldisapproximately12%.(Sincethevalueisabove
$10,000,thetrueyieldisslightlyhigherthan12%).
35.
Investment
A
B
C
D
E

(1)
Initial
Investment
$1,000
10,000
400
3,000
5,500

(2)
Future
Value
$1,200
20,000
2,000
4,000
25,000

(3)
Years
5
7
20
6
30

(4)
(1)(2)
DiscountRate
0.833
0.500
0.200
0.750
0.220

(5)
Approximate
Yield*
4%(0.822)
10%(0.513)
8%(0.215)
5%(0.747)
5%(0.231)

*FromTableA.3,AppendixA.

36. (a)

InitialInvestment $2, 500

0.417
FutureValue
$6, 000
TheclosestPVIFfor8yearsis0.404,forayieldof12%.

(b) Rosemaryshouldmaketheproposedinvestmentbecausetheyield,inboththepresentvalueand
approximateyieldcalculations,isgreaterthanher10%requiredreturn.
37. Theyieldfortheseinvestmentsisthediscountratethatresultsinthestreamofincomeequalingthe
initialinvestment.
InvestmentA:Usingthepresentvalueofanannuityformula:
PVA Annualdeposit PVIFA k%,5yrs.
$8, 500 $2, 500 PVIFA k%,5yrs.
$8, 500
PVIFA k%,5yrs.
$2, 500
3.4 PVIFA k%,5yrs.
LookingatTableA.4,AppendixA,theclosestfactorforfiveyearsoccursat14%(3.433);therefore,
thisinvestmentyieldsabout14%.

73Gitman/JoehnkFundamentalsofInvesting,NinthEdition

InvestmentB:Itisnecessarytotryseveraldifferentdiscountratestodeterminetheyieldfor
InvestmentB.Onewaytoestimateastartingpointistousetheaverageannualincomeintheformula
usedinPartAandadjustingitbasedonwhetherthelargercashflowsarereceivedintheearlieror
lateryears.TheInternalRateofReturn(IRR)functiononabusinesscalculatormakesthetaskeasier.
PVA Annualdeposit PVIFA k%,5yrs.
$9, 500 $3, 000 PVIFA k%,5yrs.
$9, 500
PVIFA k%,5yrs.
$3, 000
3.167 PVIFA k%,5yrs.
Theclosestinterestrateto3.167inTableA.4,AppendixA,is17%.Becausethelargercashflowsare
receivedinthelateryears,16%isagoodstartingpoint.

Year
1
2
3
4
5

(1)

(2)

(3)

(4)

Income
$2,000
2,500
3,000
3,500
4,000

PVIF,16%
0.862
0.743
0.641
0.552
0.476

PVat16%
$1,724.00
1,857.50
1,923.00
1,932.00
1,904.00

PVIF,15%
0.870
0.756
0.658
0.572
0.497

(5)
(1)(4)
PVat15%
$1,740.00
1,890.00
1,974.00
2,002.00
1,988.00
$9,594.00
$9,591.88

PVofIncome$9,340.50
CalculatorSolution$9,341.49
Thediscountratethatresultsinapresentvalueclosestto$9,500is15%.
CalculatorsolutionforIRR15.36

38. (a) Usingthesametechniqueasshowninthepriorquestion,wefindthat7%isapossiblediscount

rate.Becausethelargercashflowsoccurintheearlyyears,8%isagoodstartingpoint.
(1)
Year
1
2
3
4
5

Income
$6,000
3,000
5,000
2,000
1,000

(2)

(3)

8%PVIF
PVat8%
0.926
$5,556
0.857
2,571
0.794
3,970
0.735
1,470
0.681
681
PVofIncome$14,248

(4)
(1)(2)
9%PVIF
0.917
0.842
0.772
0.708
0.650

(5)
(1)(4)
PVat9%
$5,502
2,526
3,860
1,416
650
$13,954

Thediscountratethatresultsinapresentvalueclosestto$14,000is9%.
CalculatorsolutionforIRR8.85%.
(b) Elliottshouldnotmaketheproposedinvestmentbecausetheyieldinthepresentvalue
calculationislessthatthe11%requiredreturn.

Chapter4ReturnandRisk74

39.
Endof
Year
2006
2007
2008
2009
2010
2011
2012

(1)
Income
$0
140
120
100
80
60
40
1220

(2)
(3)
10%PVIF PVat10%
1
$1000
0.909
127.26
0.826
99.12
0.751
75.1
0.683
54.64
0.621
37.26
0.564
22.56
0.513
625.86

PVofIncome$41.80

(4)
(1)(2)
11%PVIF
1
0.901
0.812
0.731
0.659
0.593
0.535
0.482

(5)
(1)(4)
PVat11%
$1000
126.14
97.44
73.10
52.72
35.58
21.4
588.04
$5.58

TheYieldisverycloseto11%onthisinvestment.
Sincetheyieldof11%isgreaterthantheminimumrequiredreturnof9.0%,theinvestmentis
recommended.ThisprojectwouldresultinpositiveNetPresentValuetotheinvestor.
40. GrowthratesarecalculatedusingthepresentvalueformulaPVFVnPVIFk,n
Investment
A
n200519914
PVFV4PVIFk,4yrs.
$5.00$8.00PVIFk,4yrs
0.625PVIFk,4yrs
12%<k<13%
CalculatorSolution12.47%
B

n200519969
PVFV9PVIFk,9yrs.
$1.50$2.28PVIFk,9yrs.
0.658PVIFk,9yrs.
4%<k<5%
Calculatorsolution4.76%

n200519996
PVFV6PVIFk,6yrs.
$2.50$2.90PVIFk,6yrs.
0.862PVIFk,6yrs.
2%<k<3%
Calculatorsolution2.50%

41. 200419977years
$1FVIF?%,7years$2.21
FVIF$2.21/$12.21
FVIF12%,7years2.211,sotheyieldisabout12%

75Gitman/JoehnkFundamentalsofInvesting,NinthEdition

42. 200420004years
350FVIF?%,4years,441.7
FVIF?%,4years441.7/3501.262
FVIF6%,4years1.262,sotheyieldisabout6%
43. (a) InvestmentA,withreturnsthatvarywidelyfrom1%to26%appearstobemoreriskythan
InvestmentB,whosereturnsvaryfrom8%to16%.
n

(b) s (r r)2
i 1

CV

Standarddeviation
averagereturn

InvestmentA:

Year
2001
2002
2003
2004
2005

(1)
Return
ri
19%
1
10
26
4

(2)
Average
Return,r
12%
12
12
12
12

(3)
(1)(2)
rir
7%
11
2
14
8

(4)
(3)2
(rir)2
49%
121
4
196
64
434

434
108.5 10.42%

10.42%
CV
0.87
12.00%
SA

InvestmentB:
Year
2001
2002
2003
2004
2005

(1)
Return
ri
8%
10
12
14
16

(2)
Average
Return,r
12%
12
12
12
12

(3)
(1)(2)
rir
4%
2
0
2
4

(4)
(3)2
(rir)2
16%
4
0
4
16
40

40
10 3.16%

3.16%
CV
0.26
12.00%
SA

Chapter4ReturnandRisk76

(c) InvestmentA,withastandarddeviationof10.42,isconsiderablymoreriskythanInvestmentB,
whosestandarddeviationis3.16.ThisconfirmstheconclusionsreachedinPartA.
(d) Becausetherealbenefitofcalculatingthecoefficientorvariationisincomparinginvestments
thathavedifferentaveragereturns,thestandarddeviationisnotimprovedupon.
44. SinceInvestmentAreturnsaremuchmorevariable,InvestmentAshouldcarryahigherrisk
premium.InvestmentAsrequiredreturnis14%.

.8

Solutions to Case Problems

Case 4.1Solomons Decision

Thiscaseintroducesthestudenttotheconceptsofopportunitycostandrequiredrateofreturn.Itfurther
requiresstudentstocomputepresentvaluesandselectinvestmentsusingthereasonablereturnapproach
discussedinthechapter.
(a) Usingthepresentvaluetechniquefortheequallyriskyprojects,weselecttheonewiththehighest
presentvalue(netofthepurchasepriceoftheinvestment$1,050forbothinvestments)ifthepresent
valueexceedstheinvestmentcost.
PresentvalueofA:Thisisthepresentvalueofanineyear$150annuityplus1paymentinyear10of
$1,150,sowewillusethepresentvalueinterestfactorforanannuityfromTableA.4,AppendixA,
andthepresentvalueinterestfactorforadollarfromTableA.3.
PVA $150 PVIFA12%,9yrs. $1,150 PVIF12%,10yrs.
$150 5.328 $1,150 0.322
$799.20 $370.30
$1,169.50
PresentvalueofB:Thisisthepresentvalueofamixedstream,soweusethepresentvalueinterest
factorsforonedollarfromTableA.3.
(1)
Year
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015

Benefit
$100
150
200
250
300
350
300
250
200
150

(2)

(3)
(1)(2)
PVIF(12%) PresentValue
0.893
$89.30
0.797
119.55
0.712
142.40
0.636
159.00
0.567
170.10
0.507
177.45
0.452
135.60
0.404
101.00
0.361
72.20
0.322
48.30
$1,214.90
TotalPV

77Gitman/JoehnkFundamentalsofInvesting,NinthEdition

Eachinvestmentisacceptablebecauseitspresentvalueisgreaterthanitsinitialcostof$1,050.
However,thepresentvalueofBishigherthanA,andsincebothcost$1,050,Bwouldbethe
preferredinvestment.Ifbothareequallyrisky,Bhasahigherreturn($1,214.90)foritslevelofrisk
thanA($1,169.50).

Chapter4ReturnandRisk78

(b) Forprojectsofunequalrisk,wemustevaluateeachatitsrequiredrateofreturn(adjustedforitslevel
ofrisk).Usinga16percentinterestfactor(fromTableA.3,AppendixA),thepresentvalueof
InvestmentBis:
(1)
Year
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015

Benefit
$100
150
200
250
300
350
300
250
200
150

(2)

(3)
(1)(2)
PVIF(16%)
PresentValue
0.862
$86.20
0.743
111.45
0.641
128.20
0.552
138.00
0.476
142.80
0.410
143.50
0.354
106.20
0.305
76.25
0.263
52.60
0.227

34.05
TotalPV$1,019.25

Since$1,019.25,thepresentvalueofinvestmentB,doesnotremaingreaterthanitscost($1,050),itis
nolongeranacceptableinvestment.InvestmentAistheonlyoneofthetwoearningareasonable(i.e.,
acceptable)return.
(c) SinceInvestmentAwasacceptable(hadapositivepresentvalue)atadiscountrateof12percent,its
yieldmustbemorethan12percent.InvestmentBwasacceptableatadiscountrateof12percent,so
itsyieldisalsogreaterthan12%.However,InvestmentBsyieldisbetween12and16percent.The
presentvalueofBat12percentequaled$1,214.90,andat16percentitwas$1,019.25.Sincethe
presentvalueat16percentisclosertothecostthanthepresentvalueat12percent,theactualyieldis
closerto16percent.Itappearstobeabout15.25percent.(Theactualyieldcomputedusinga
calculatoris15.31percent.)
(d) InvestmentA:
Presentvaluetechnique:
Step1:Findthepresentvalueof$150incomefor9yearsusingthepresentvalueofanannuity
formula.
Step2:FindthePVof$1,150inyear10.
Step3:AddthetwoamountstogetthetotalPV.Trydifferentdiscountratestodeterminetheyield
(IRR).Becauseweknowfromquestion1thatthepresentvalueat12%is$1,196.50,justabovethe
initialinvestmentamount,startwith13%:
Step1.PVA13%,9yrs. Annualincome PVIFA13%, 9yrs.
$150 5.132
$769.80

Step2.PV13%,10yrs. IncomeinYear10 PVIF13%,10yrs.

Step3.TotalPV

$1,150 0.295
$339.25
$769.80 $339.25 $1,109.05

79Gitman/JoehnkFundamentalsofInvesting,NinthEdition

Try14%:
Step1.PVA14%, 9yrs. Annualincome PVIFA14%,9yrs.
$150 4.946
$741.90

Step2.PV14%,10yrs. IncomeinYear10 PVIF14%,10yrs.

Step3.TotalPV

$1,150 0.270
$310.50
$741.90 $310.50 $1, 052.40

Yield14%
InvestmentB:BecausethepresentvalueoftheincomefromInvestmentBis$1,019.25at16%
(Question2),trya15%discountrate:
(1)
Year
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015

Benefit
$100
150
200
250
300
350
300
250
200
150

(2)

(3)
(1)(2)
PVIF(15%) PresentValue
0.870
$87.00
0.756
113.40
0.658
131.60
0.572
143.00
0.497
149.10
0.432
151.20
0.376
112.80
0.327
81.75
0.284
56.80
0.247

37.05
TotalPV$1,063.70

Yieldis15%(Calculatorsolution:15.31%)
(e) BecauseInvestmentAisacceptableata12percentdiscountratewhileInvestmentBisunacceptable
ata16percentdiscountrate,InvestmentAisrecommended.AlthoughitseemsasifinvestmentBis
beingpenalizedwithahigherdiscountrate,duetoitsgreaterriskitmustearna16percentyieldtobe
acceptable.
(f) Hisinitialinvestmentof$50wouldhavegrownto$81.45attheendofthetenyearsassumingthathe
makesnowithdrawalsfromhissavingsaccount.Thisiscalculatedusingafuturevalueinterestfactor
fromTableA.1,asillustratedbelow:
FV5%,10yrs.$501.629$81.45

Chapter4ReturnandRisk80

Case 4.2The Risk-Return Tradeof: Molly ORourkes Stock Purchase Decision

Thetitleofthiscaseclearlystatesitsobjective.Itrequiresstudentstoreviewandapplytheconceptofthe
riskreturntradeoff.
(a) HPR

CurrentIncome EndingPrice BeginningPrice

BeginningPrice

HPRforStockX:

Year
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005

(1)

(2)

(3)

Current
Income
$1.00
1.50
1.40
1.70
1.90
1.60
1.70
2.00
2.10
2.20

Ending
Price
$22.00
21.00
24.00
22.00
23.00
26.00
25.00
24.00
27.00
30.00

Beginning
Price
$20.00
22.00
21.00
24.00
22.00
23.00
26.00
25.00
24.00
27.00

(4)
(2)(3)
Capital
Gain
$2.00
1.00
3.00
2.00
1.00
3.00
1.00
1.00
3.00
3.00

(5)
[(1)(4)]/(3)

(4)
(2)(3)
Capital
Gain
$0.00
0.00
1.00
0.00
1.00
1.00
0.00
1.00
1.00
0.00

(5)
[(1)(4)]/(3)

HPR
15.00%
2.27
20.95
1.25
13.18
20.00
2.69
4.00
21.25
19.26

Average(expected)HPRforstockX11.74%
HPRforStockY:

Year
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005

(1)

(2)

(3)

Current
Income
$1.50
1.60
1.70
1.80
1.90
2.00
2.10
2.20
2.30
2.40

Ending
Price
$20.00
20.00
21.00
21.00
22.00
23.00
23.00
24.00
25.00
25.00

Beginning
Price
$20.00
20.00
20.00
21.00
21.00
22.00
23.00
23.00
24.00
25.00

Average(expected)HPRforstockY11.14%

HPR
7.50%
8.00
13.50
8.57
13.81
13.64
9.13
13.91
13.75
9.60

81Gitman/JoehnkFundamentalsofInvesting,NinthEdition
n

(b) s
i 1

(ri r)2
N 1

InvestmentX:

Year
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005

(1)
Return
ri
15.00%
2.27
0.95
1.25
13.18
20.00
2.69
4.00
21.25
19.26

(2)
Average
Return,r
11.74%
11.74
11.74
11.74
11.74
11.74
11.74
11.74
11.74
11.74

sX

(3)
(1)(2)
rir
3.26%
9.47
9.21
12.99
1.44
8.26
9.05
7.74
9.51
7.52

(4)
(3)2
(rir)2
10.63%
89.68
84.82
168.74
2.07
68.23
81.90
59.91
90.44
56.55

712.97

712.97
79.22 8.9%
10 1

Coefficientofvariation8.9%/11.74%0.76
InvestmentY:

Year
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005

(1)
Return
ri
7.50%
8.00
13.50
8.57
13.81
13.64
9.13
13.91
13.75
9.60

(2)
Average
Return,r
11.14%
11.14
11.14
11.14
11.14
11.14
11.14
11.14
11.14
11.14
sY

(3)
(1)(2)
rir
3.64%
3.14
2.36
2.57
2.67
2.50
2.01
2.77
2.61
1.54

(4)
(3)2
(rir)2
13.25%
9.86
5.57
6.60
7.13
6.25
4.04
7.67
6.81
2.37

69.55
7.73 2.78%
10 1

Coefficientofvariation2.78%/11.14%0.25

Chapter4ReturnandRisk82

(c)and(d)
SummaryStatistics:
ExpectedReturn
StandardDeviation
CoefficientofVariation

InvestmentX
11.74%
8.82
0.76

InvestmentY
11.14%
2.78
0.25

Comparingtheexpectedreturnscalculatedinquestion1,StockXprovidesareturnof11.74percent,
whichisonlyslightlyabovetheexpectedreturnofY(11.14percent).Whetherthehigherreturnon
StockXissufficienttocompensateforthehigherriskwouldbedeterminedbythepriceofriskin
thefinancialmarkets.
Ascanbeseen,StandardDeviationandCoefficientofvariationofStockXishigherthanthe
correspondingvaluesofstockY.ThismightbeasignaltopreferstockY.Butthesenumbershaveto
beinterpretedwithcautionasoneoftheabovestocksistobeaddedtoawelldiversifiedportfolio.
ThispartofthecaseproblemanticipatestheuseofbetaandCAPM,whichwillbecoveredinthenext
chapteronmodernportfolioconcepts.Thecalculationofrequiredreturnprovidesanobjective
approachtoassesstheinvestmentrisk.
Usingthecapitalassetpricingmodel,therequiredreturnoneachstockisasfollows:
CapitalAssetPricingModel:riRf[bI(rmRF)]
Investment
A
B

Rf[bI(rmRF)]

11.8%7%[1.6(10%7%)
10.3%7%[1.1(10%7%)

Fromthecalculationsinquestion1,StockXhasanexpectedreturnof11.74%andarequiredreturnof
11.8%.Ontheotherhand,StockYhasanexpectedreturnof11.14%andarequiredreturnofonly
10.3%.
SowhileweconcludedthatitwouldbedifficulttomakeachoicebetweenXandYbecausethe
additionalreturnonXmayormaynotprovidetheneededcompensationfortheextrarisk,weseethat
bycalculatingarequiredrateofreturn,itiseasytorejectXandinvestinY.Therequiredreturnon
StockXis11.8%,whichishigherthanexpectedreturn(11.74%);thereforeStockXisunattractive.
Usingthesamelogic,StockYisabetterinvestmentvehicle.
Clearly,Mollyisbetteroffusingbetaratherthanastrictlysubjectiveapproachtoassessinvestment
risk.TheuseofbetaandCAPMallowsrisktobequantifiedandconvertedintoarequiredreturnthat
canbecomparedtotheexpectedreturntodrawadefinitiveconclusionaboutinvestmentacceptability.
Thestudentwillmeettheseconceptsinthenextchapter.