RISK, RETURN AND CAPITAL BUDGETING

- APPLICATIONS -

1. Micro-Pub

Micro-Pub, Inc., is considering the purchase of one of two microfilm cameras, R and S. Both should provide benefits over a 10-year period, and each requires an initial investment of $4,000. Management has constructed the following table of estimates of rates of return and probabilities for pessimistic, most likely and optimistic results.

a)      Determine the range for the rate of return for each of the two cameras.

b)      Determine the expected value of return for each camera.

c)      Purchase of which camera is riskier? Why?

2. Perth Industries

Three assets - F, G and H - are currently being considered by Perth Industries. The probability distributions of expected returns for these assets are shown in the following table.

a)      Calculate the expected value of return for each of the three assets. Which provides the largest expected return?

b)      Calculate the standard deviation for each of the three assets' returns. Which appears to have the greatest risk?

c)      Calculate the coefficient of variation for each of the three assets' returns. Which appears to have the greatest relative risk?

3. Stocks and T-bonds

1. Consider the following scenario analysis:

a)      Calculate the expected rate of return and standard deviation for each investment.

b)      Which investment would you prefer?

4. Portfolio

Use the data in the previous problem and consider a portfolio with weights of 60% in stocks and 40% in bonds.

a)      What is the rate of return on the portfolio in each scenario?

b)      What is the expected rate of return on the portfolio?

c)      What is the standard deviation on the portfolio?

d)      Would you prefer to invest in the portfolio, in stocks only, or in bonds only?

5. M. Grandet

M. Grandet has invested 60 percent of his money in share A and the remainder in share B. He assesses their prospects as follows:

a)      What are the expected return and standard deviation of returns on his portfolio?

b)      How would your answer change if the correlation coefficient was 0 or -0.5?

c)      Is M. Grandet's portfolio better or worse that one invested entirely in share A, or is it not possible to say?

6. Market risk

A stock will provide a rate of return of either -20% or +30%.

a)      If both possibilities are equally likely, calculate the expected return and standard deviation.

b)      If Treasury bills yield 5%, and investors believe that the stock offers a satisfactory expected return, what must the market risk of the stock be?

7. Beta and IRR

A project under consideration has an internal rate of return of 14% and a beta of 0.6. The risk-free rate is 5% and the expected rate of return on market portfolio is 14%.

a)      Should the project be accepted?

b)      Should the project be accepted if its beta is 1.6?

c)      Why do your answers change?

8. T-bill rate

The Treasury bill rate is 4 percent, and the expected return on the market portfolio is 12 percent. On the basis of the CAPM:

a)      Draw a graph showing how the expected return varies with beta.

b)      What is the risk premium on the market?

c)      What is the required return on an investment with a beta of 1.5?

d)      If an investment with a beta of 0.8 offers an expected return of 9.8 percent, does it have a positive NPV?

e)      If the market expects a return of 11.2 percent from stock X, what is its beta?

9. Centennial Catering

Centennial Catering, Inc., is considering two mutually exclusive investments. The company wishes to use a risk-adjusted rate of return in its analysis. The market return is 12% and the current risk-free rate of return is 7%. Cash flows associated with the two projects are as follows:

a)      Use the risk-adjusted rate of return to calculate the net present value of each project, given that Project X has a beta of 1.20 and Project Y has a beta of 1.40.

b)      Discuss your findings in part a), and recommend the preferred project.