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Part Two

Important Conceptual Tools


Part Two Includes
Chapter 4 Return and Risk
Chapter 5 Modern Portfolio Concepts
Chapter 4
Return and Risk
.1 Outline
Learning Goals
I. The Concept of Return
A) Components of Return
1. Current Income
2. Capital Gains (or Losses)
B) Why Return Is Important
1. Historical Performance
2. Expected Return
C) Level of Return
1. Internal Characteristics
2. External Forces
D) Historical Returns
Concepts in Review
II. The Time Value of Money
A) Interest: The Basic Return to Savers
1. Simple Interest
2. Compound Interest
B) Computational Aids for the Use of Time Value Calculations
1. Financial Calculators
2. Computers and Spreadsheets
C) Future Value: An Extension of Compounding
D) Future Value of an Annuity
E) Present Value: An Extension of Future Value
F) The Present Value of a Stream of Income
1. Present Value of a Mixed Stream
2. Present Value of an Annuity
G) Determining a Satisfactory Investment
Concepts in Review
III. Measuring Return
A) Real, Risk-Free, and Required Returns
B) Holding Period Return
1. Understanding Return Components
2. Computing the Holding Period Return (HPR)
3. Using the HPR in Investment Decisions
C) Yield: The Internal Rate of Return
1. Yield for a Single Cash Flow
2. Yield for a Stream of Income
3. Interest-on-Interest: The Critical Assumption
D) Finding Growth Rates
Concepts in Review
IV. Risk: The Other Side of the Coin
A) Sources of Risk
1. Business Risk
2. Financial Risk
3. Purchasing Power Risk
4. Interest Rate Risk
5. Liquidity Risk
6. Tax Risk
7. Market Risk
8. Event Risk
B) Risk of a Single Asset
1. Standard Deviation: An Absolute Measure of Risk
2. Coefficient of Variation: A Relative Measure of Risk
3. Historical Returns and Risk
C) Assessing Risk
1. Risk-Return Characteristics of Alternative Investment Vehicles
2. An Acceptable Level of Risk
3. Steps in the Decision Process: Combining Risk and Return
Concepts in Review
Summary
Putting Your Investment Know-How to the Test
Discussion Questions
Problems
Case Problems
4.1. Solomons Decision
4.2. The Risk-Return Tradeoff: Molly ORourkes Stock Purchase Decision
Excel with Spreadsheets
Trading Online with OTIS
51 Gitman/Joehnk Fundamentals of Investing, Ninth Edition
.2 Key Concepts
Chapter 4 Return and Risk 52
1. The concept of return, its component parts, and the forces that affect the level of return realized by an
investor. Historical returns are reviewed.
2. Interest income and the concept of time value, its underlying future and present value computations,
and its use in the investment decision-making process.
3. Usage of financial calculators, computers, and spreadsheets in measuring risk and return.
4. Real, risk-free, and required returns on investments.
5. The computation and use of the holding period return and the internal rate of return, and the role yield
can play in the investment decision.
6. The sources and basic types of risk, the concept of risk, its positive relationship to return, and its role
in investment decision-making.
7. The basic steps involved in evaluating the risk-return characteristics of an investment.
.3 Overview
The concepts of return and risk are developed in this chapter. The chapter is conceptually more demanding
than the preceding one, so the instructor should plan to spend more class time on it.
1. Returns are rewards for investing. The components of total return are current income and capital
gains (or losses). Current income is income received in cash or near-cash, whereas capital gains
refers to income that is attributed to an increaserealized or unrealizedin the value of the
investment.
2. Expected return motivates a person to invest in a particular vehicle. Expectations of returns are based
on the past returns of that vehicle. Measuring the historical return of a particular investment reveals
its average return as well as the trend of its returns. The instructor may demonstrate this by discussing
Table 4.3 in class.
3. The level of returns for a particular investment vehicle depends on internal characteristics, such as
type of investment and issuer characteristics, and external forces, such as war, political events, and
the level of price changes (inflation or deflation).
4. The vitally important concepts of the time value of money, future value, and present value are
covered next. These concepts are best explained by working through a few examples that deal with
single sums, annuities, and mixed streams. The instructor should emphasize that present value
calculations provide a dollar value (in todays terms) of future cash flows. The present value concept
is a powerful tool that makes it possible to compute the dollar value of any asset. Some assets that
might be profitably considered in class are stocks, bonds, other financial assets, physical assets
(machines), real estate, and even companies themselves.
5. A satisfactory investment is one in which the present value (PV) of benefits (discounted at the
appropriate rate) equals or exceeds the PV of costs. The instructor may indicate that NPV (PV of
benefits minus PV of costs) measures the same thing.
53 Gitman/Joehnk Fundamentals of Investing, Ninth Edition
6. The required return of an investment is the rate which compensates the investor for its risk. It is
composed of the real rate of returnthe return earned in a perfect world with no riskplus the
expected inflation premium, which is called the risk-free rate, plus the risk premium for the
investment.
7. The holding period return (HPR), defined next, is useful in making investment decisions. The
instructor may show the class how HPR is computed in Table 4.11, stressing that the HPR from
identical periods should be used when comparing two investments.
8. Yield, also called the internal rate of return (IRR), represents the annual rate of return earned on a
long-term investment. A satisfactory investment is one that has a yield equal to or greater than the
appropriate discount rate. Some instructors may want to spend time discussing the critical assumption
interest-on-interestthat underlies yield. Others may choose to skip this technical, but important,
discussion. Those who cover interest-on-interest should find Figure 4.3 helpful in explaining it. At
this point, the instructor should have made it clear to the class that the returns from an investment
may be measured either in dollar or percentage terms.
9. The calculation of growth rates for streams of dividends or earnings, a present value application that
is an important part of common stock valuation, is covered next.
10. The concept of risk is next introduced and defined. The possible sources of risk include business risk,
financial risk, purchasing power risk, interest rate risk, liquidity risk, tax risk, market risk, and event
risk. The basic types of risk include diversifiable, nondiversifiable, and total. Next introduced is the
risk of a single asset, the standard deviation as a measure of absolute risk, and the coefficient of
variation as a relative measure of risk. The risk-return tradeoff is also discussed.
11. The texts description of the four steps in the investment process are useful and should be
highlighted.
.4 Answers to Concepts in Review
1. The return on investment is the expected profit that motivates people to invest. It includes both
current income and/or capital gains (or losses). Without a positive expected return, there is no benefit
to investing and individuals have no reason to save and invest. Since net demanders are willing to pay
net savers a positive return for their funds, the opportunity to earn a positive return exists.
Return on investment can come from either current income or capital gains, or both. Current income,
most commonly, is periodic payments, such as interest received on bonds, dividends on stock, or rent
received from real estate. To be considered income, these payments must be received in cash or be
readily convertible to cash. Capital gain refers to the change in the market value of the investment.
The amount by which the proceeds from the sale of an investment exceed the original purchase is
called a capital gain. If it is sold for less than the original purchase price, a capital loss is realized.
The use of percentage returns is generally preferred to dollar returns to allow investors to directly
compare different sizes and types of investments.
2. Although future returns are not guaranteed by past performance, historical data often gives the
investor a meaningful basis on which to form future expectations. Past return data, such as average
returns or trends seen in certain time periods, can be used along with the investors insights about
future prospects of the investment. Together the historical data and future prospects help the investor
to formulate an expected return on the investment.
Chapter 4 Return and Risk 54
The level of expected returns depends on many internal characteristics of the investment and the
external forces on the investment. Internal characteristics include the type of investment, the quality
of management, the method by which the investment is financed, and the customer base of the issuer.
External forces include war, shortages, price controls, Federal Reserve actions, and political events,
among others. External forces, unlike internal characteristics, cannot be controlled by the issuer of the
investment. Investment vehicles are affected differently by these forcesthe expected return of one
investment may increase while the expected return of another may decrease in response to external
forces.
History tells us that stock market returns have averaged well above the interest rates payable on
savings accounts at banks. In recent years especially during the latter part of the 1990s the returns
were well above the stock market averages for the earlier part of the century. Unfortunately, the
article does not provide a clear message for investors other than history can repeat itself. If the
investor is looking for short-term gains over a year or two, the probabilities are mixed depending on
what time periods are cited. The best advice, given these statistics, is to invest to hold for the long
term in order to ride out the markets twists and turns.
3. Time value of money refers to the fact that, with the opportunity to earn interest on funds, the value of
money depends on the point in time when the money is expected to be received. Thus, the sooner one
receives money the betterthe more valuable is that money.
Because money has time value, people willing to invest their money should be able to earn a positive
return. For example, an investor expecting to receive a $100 interest payment for 2 different
securities doesnt necessarily value them equally. If the first investment pays the interest at the end of
one year, but the second investment pays the interest at the end of two years, the first investment will
be more valuable. The $100 can be reinvested to earn interest for an entire year. At the end of Year 2,
the first investment has returned $100 + interest, the second has returned $100 to the investor. The
$100 reinvestment has earned a positive return; the other $100 has not had a chance to accumulate
interest.
4. (a) Interest is the current income you receive from placing available funds in a savings account, CD,
bond, or by making a loan. It is in effect the rent paid on your money by those who obtain use
of it.
(b) Simple interest is interest paid (earned) only on the initial balance for the actual amount of time it
is on deposit. With simple interest, the stated interest rate is always equal to the true rate of
interest (or return).
(c) Compound interest is interest paid not only on the initial deposit but also on interest accumulated
from one period to the next. This is the method savings institutions generally employ. When
interest is compounded annually, the simple, compound, and true rates of interest are the same.
(d) The true rate of interest (or return) takes the concept of compounding into account. When
interest is compounded annually, the stated and true interest rates are equal. For more frequent
compounding, the true rate of interest would be higher than the stated rate. Hence an APR of
15% on a credit card which is compounded daily has a true interest rate of 16.18%.
5. The true rate of interest rises as interest is compounded more frequently than annually. The true and
stated rates are the same when interest is compounded annually. Continuous compounding occurs
when interest is compounded over the smallest possible time period.
6. The future value of a cash flow represents the amount to which a current deposit will grow over a
given time period if it is placed in an account paying compound interest. Present value is concerned
with finding the current value of a future sum, given that the investor earns a stated returnthe
discount rate (or opportunity cost)on similar investments. The discount rate is the rate at which
future sums are discounted to find their present values. The present value concept is the inverse of the
future value concept.
55 Gitman/Joehnk Fundamentals of Investing, Ninth Edition
7. An annuity is a stream of equal cash flows that occur in equal intervals over time. These cash flows
can be paid out or received. An ordinary annuity has cash flows occur at the end of each year. To
simplify the calculation of the future value of an annuity, one can use the future value interest factor
of the annuity table included in Appendix A, Table A.2. The present value of an annuity can be found
similarly in the present-value interest factor of the annuity table in Appendix A, Table A.4.
Calculators are also designed with annuity PMT keys.
8. A mixed stream of returns is a series of returns that exhibits no pattern. To find the present value of a
mixed stream, calculate the present value of each component of the mixed stream. The summation of
the present value of individual components gives us the present value of the entire mixed stream.
9. Ignoring risk, a satisfactory investment is one for which the present value of benefits (discounted)
equals or exceeds the present value of costs. If the present value of benefits exceeds the cost, the
investor would earn more than the discount rate i.e. the return on the investment is greater than the
discount rate.
10. (a) The real rate of return is the return earned in a certain, risk-free world. It would equal the
nominal rate of return on a risk-free security less inflation. Historically, it has been relatively
stable in the range of 0.5 to 2%.
(b) The expected inflation premium represents the expected average future rate of inflation. It is the
compensation that investors demand for future expected inflation; that is, the decline in the
purchasing power of the dollar.
(c) The risk premium varies for different security issues and represents the additional return required
to compensate an investor for the risk characteristics of the issue and the issuer. It is the return on
a risk security (e.g. stocks, bonds) minus the risk-free rate of return, which is the rate on a 90-day
T-Bill.
The risk-free rate of return equals the real rate of return plus the expected inflation premium:
RF = r
*
+ IP. It is the return on a riskless security as measured by the 90-day T-Bill.
The required rate of return equals the real rate of return plus the expected inflation premium
(together, the risk-free rate) and the risk premium: ri = RF + IP. Alternatively, it equals the risk-
free rate of return plus the risk premium.
11. The holding period is simply the period of time over which the investor wishes to measure the return
on an investment. In comparing alternative investment vehicles, it is essential to use equal-length
holding periods so that the two vehicles being compared are judged under identical conditions. This
adds objectivity to the comparison. Most interest rates are quoted on an annual basis, so it is generally
convenient to use a one-year holding period.
The holding period return (HPR) is the total return earned from holding an investment for a specified
period of time. To calculate HPR, all that is needed is the beginning- and end-of-period investment
values along with the value of current income received by the investor. Because HPR doesnt account
for the time value of money, the holding period is usually one year or less.
12. The yield, or IRR, is the annual rate of return earned by a long-term investment. It is also defined as
the discount rate that produces a present value of benefits received equal to the present value of
costs/investments. Unlike the HPR, it takes into account the time value of money and can be used to
calculate the return on investments held for over one year. The HPR is inappropriate for investments
held for more than one year.
Chapter 4 Return and Risk 56
13. The critical assumption underlying the use of yield as a return measure is an ability to earn a return
equal to the calculated yield on all income received from the investment during the holding period. If
you earn 10 percent on all income received from an investment during the holding period, your yield
on the investment will be 10 percent. On the other hand, if you earn 0 percent on the income
received, your rate of return on the investment would actually be less than 10 percent. If the interest-
on-interest earned from the investment is less than its calculated yield, the investments return will
fall below the yield. Clearly when using yield as a measure of investment return, the validity of this
assumption must be recognized and evaluated. If the interest-on-interest assumption does not hold,
use of the calculated yield could lead to poor investment decisions. (Note: The instructor may want to
use the discussion of interest-on-interest and Figure 4.3 to demonstrate this somewhat complex, but
extremely important, yield concept.)
14. If the present value of returns from an investment is greater than the initial cost of the investment, it
is a satisfactory investment and should be acceptable. If the yield from an investment is greater than
the appropriate discount rate for that investment, the present value and yield provide the same
conclusion regarding acceptability.
In the example given, Investment A is clearly acceptable since its yield (8 percent) is greater than the
appropriate discount rate (7 percent). Investment B, on the other hand, is not acceptable since its
present value of returns ($150) is $10 less than its cost ($160). Investment C is not acceptable since
its yield (8 percent) is lower than the appropriate discount rate (9 percent).
15. Risk is the chance that the actual return from an investment may differ from what is expected. The
standard deviation is the statistic used to measure risk. The risk-return tradeoff is the relationship
between the expected returns from an investment and the risk associated with them. The required
returns from an investment increase as risk increases to provide an incentive for him or her to take
higher risks i.e. in order to accept higher risks, the investors have to be compensated with higher
returns.
16. (a) Business risk is concerned with the degree of uncertainty associated with an investments
earnings and the investments ability to pay investors interest, dividends, and other returns owed
them. Business risk is usually related to the firms line of business.
(b) Financial risk is the risk associated with the mix of debt and equity (capital structure) used to
finance the firm. The greater the firms debts and interest obligations, the greater its financial
risk.
(c) Purchasing power risk arises because of uncertain inflation rates and price-level changes in the
future. When prices rise, each dollar invested has less valueit can buy less, and vice versa.
(d) Interest rate risk is risk associated with changes in the prices of fixed-income securities resulting
from changing market interest rates. As the market interest rates change, the prices of these
securities change in the opposite direction, thereby changing the level of return that an investor
can expect to obtain from them. Another important aspect of interest rate risk involves the ability
to reinvest income received at the initial rate of return in order to earn the fully compounded rate
of return.
(e) Liquidity risk is the risk of not being able to liquidate an investment conveniently and at a
reasonable price. In general, investment vehicles traded in markets with small demand and
supply characteristics tend to be less liquid than those traded in broad markets.
(f) Tax risk is the risk that tax laws enacted by Congress will adversely affect certain types of
investments and decrease their after-tax returns.
57 Gitman/Joehnk Fundamentals of Investing, Ninth Edition
(g) Market risk is the risk of changes in investment returns caused by factors independent of the
given investment vehicle. It results from factors such as political, economic, and social events, or
changes in investor tastes and preferences.
(h) Event risk is the risk that comes from a largely or totally unexpected event which has a
significant and usually immediate effect on the underlying value of an investment. The effect of
this risk seems to be isolated in most cases, affecting only certain companies and properties.
17. Standard deviation is the most common measure of an assets risk. It measures the dispersion of
returns around an assets average or expected return. Standard deviation is an absolute measure of
risk, and thus can be used to compare the riskiness of competing investments with the same expected
return. The coefficient of variation (CV) measures the relative dispersion of an assets average or
expected returns. Like standard deviation, the higher the CV, the higher the risk. CV differs from
standard deviation because it is a relative measure of risk and can be used to compare the riskiness of
competing investments with different expected returns.
18. Investors attitudes toward risk or their risk-return tradeoffs may be classified as one of the following:
Risk-indifferent investors do not require a greater return in exchange for each unit of additional risk.
Risk-averse investors require greater return in exchange for each unit of additional risk. The trade-off
here is positive; return must increase as risk increases.
Risk-taking investors accept a lower return in exchange for greater risk. This tradeoff is negative;
such investors enjoy risk and are therefore willing to accept lower returns for increasing levels of
risk.
In general, most investors are risk-averse. They require increased returns from an investment as its
risk increases. The risk preference of an investor is an important determinant of his/her investment
decisions. Risk-averse investors may not make speculative investments, while risk-taking investors
may. Thus, an investment that is considered unsatisfactory by a risk-averse investor may be deemed
satisfactory by a risk-taking investor.
19. The investment process can be summarized in four steps:
(1) Estimate the expected return over a given holding period using historical data or projected return
data, or both. The time value of these returns must be considered for long-term investments.
(2) Assess the risk of the investment returns through the subjective (judgmental) evaluation of
historical returns and by using beta (for securities).
(3) Evaluate the risk-return behavior of each alternative investment. The expected return must be
reasonable given the level of risk possessed by the investment. Only investments offering the
highest expected return for a given level of risk are considered reasonable.
(4) Select the vehicles with the highest return for the level of risk the investor is willing to take.
These fit the definition of a good investment.
Chapter 4 Return and Risk 58
.5 Suggested Answers to Investing in Action Questions
Many Happy Returns . . . Maybe (p. 137)
(a) What has history taught us about the stock market?
(b) What should you do to ride out the markets twists and turns?
Answers:
(a) Stocks have outperformed bonds and cash in four out of five years, with an average annual return of
12.2 percent from 19262002. Long-term bonds earned 6.2%, on average, annually over the same
period. The stock market performed the best during business expansions, which lasted 35 months on
average.
(b) First, employ a long investment horizon and let compounding work in your favor. Second, focus on
future share prices. Third, invest as much as you can. Fourth, diversify.
Whats Your Risk Tolerance? (p. 169)
What is your personal risk tolerance and appropriate set of investments?
Answer:
Risk tolerance will vary across students. Figure 4.4 would direct the conservative investor towards
diversification among U.S. government securities, deposit accounts, bonds and preferred stock. Moderate
risk investors would be directed to preferred stock, convertible securities, common stock and real estate.
Aggressive investors would be directed towards common stock, real estate, options, and futures.
.6 Suggested Answers to Ethics in Investing Questions
Fraud at Tyco International (at Web Site)
Should firms be able to write off intangible assets (such as goodwill), or amortize them over time?
Answer:
For companies like Tyco International that made large number of acquisitions, goodwill and intangible
assets often represent a considerable portion of an enterprises value, and recent accounting changes will
have an important effect on financial statements. Rather than using the pooling method of accounting,
where assets are allowed to be amortized over their useful life (up to 40 years), goodwill and other
intangibles from past or future mergers and acquisitions will now be subject the purchase method of
accounting and testing for asset impairment. Pooling transactions sometimes allowed companies to hide
the purchase price of the acquired business while the purchase method did not. Some empirical evidence
suggests companies paid a premium to pool assets to avoid goodwill amortization. However, the
economics of merger is the same regardless which accounting treatment companies applied. If the markets
valued pooling companies higher that worked to the advantage of such businesses at the expense of the
companies that applied purchase accounting. In case of Tyco, where there have been allegations of serious
misconduct and overpayment for acquired assets, the new rules would increase the transparency of
operations rather than hiding inefficiencies under the rug by pursuing new acquisitions. Goodwill write off
information in financial statements provides additional clarity and valuable insight on how companies are
faring.
59 Gitman/Joehnk Fundamentals of Investing, Ninth Edition
.7 Suggested Answers to Discussion Questions
Answers will vary according to students selections, tastes, and preferences.
.8 Solutions to Problems
1. The investor would earn $8.25 on a stock that paid $3.75 in current income and sold for $67.50. Part
of the total dollar return includes a $4.50 capital gain which is the difference between the proceeds of
the sale and the original purchase price ($67.50 $63.00) of the stock.
2. The investor had interest income of $900 (three payments of $300 each), and a capital loss of $500.
3. (a) Current income: = $2.70
(b) Capital gain: $60 $50 = $10
(c) Total return:
(1) In dollars: $2.70 + $10.00 = $12.70
(2) As a percentage of the initial investment: $12.70 = 0.25 or 25%.
50.00
4. (a) Current income is the interest income, which is equal to $900 (three payments of $300).
(b) Capital gain is $10,000 $9,500 = $500
(c) Total return = $900 + $500 = $1,400. $1,400/$9,500 = 14.7%.
5. (a) Total return = Current income + Capital gains (or losses) where:
Capital gains (or losses) = Ending price Beginning price
(1) (2) (3) (4) (5)
(1) (2) (3) + (4)
Year
Ending
Price
Beginning
Price =
Capital
Gain +
Current
Income =
Total
Return
2001 $32.50 $30.00 $2.50 $1.00 $3.50
2002 35.00 32.50 2.50 1.20 3.70
2003 33.00 35.00 2.00 1.30 0.70
2004 40.00 33.00 7.00 1.60 8.60
2005 45.00 40.00 5.00 1.75 6.75
(b) Of course, there is no correct answer here, but one might forecast using the arithmetic average or
the average one-year holding period return.
(i) The arithmetic average:
$3.50 $3.70 $0.70 $8.60 $6.75
$4.37
5
+ + +
=
(ii) The average holding period return (HPR):
Ending price Beginning price Current income Total Return
HPR
Beginning price Beginning Price
+
= =
Chapter 4 Return and Risk 60
(1) (2) (3)
Year
Total
Return*
Beginning
Price
(1) (2)
HPR
2001 $3.50 $30.00 11.7%
2002 3.70 32.50 11.4
2003 0.70 35.00 2.0
2004 8.60 33.00 26.1
2005 6.75 40.00 16.9
*From part (a) in the previous page.
11.7 11.4 2.0 26.1 16.9
Average HPR 12.8%
5
+ + +
= =
(b)
(i) (ii)
Forecasts
for:
Based on
Arithmetic Average
Based on
Average HPR
2006 $4.37 ($45.00) * 0.128 = $5.76
2007 $4.37 ($49.00)** 0.128 = $6.27
*End of 2005 price gain in original data.
**For lack of information, we are assuming the 2006 return is $4.00 from capital
gains and $1.76 from current income.
(c) Students should be made aware of the fact that many other forecasts are possible. Other factors
may be relevant here: Will the pattern of two good years followed by a bad one continue? Do
future prospects seem bright? (We will discuss forecasting returns on specific investment
vehicles in later chapters.)
6. Total return = current income plus capital gains.
Current income = 100 ($1 + $1.2 + $1.3) = $350.
Capital gain = $100 ($33 $30) = $300.00.
Total return = $350 + $300 = $650.
As a percent of the original investment: $650/(100 $30 = $3,000) = 21.7%.
7. The simple interest calculations for parts (a) and (b) can be presented in tabular form:
(b) (a)
Date
Beginning
Balance*
Annual
Interest
Ending
Balance**
1/1/05 $5,000 $5,000 0.06 = $300 $5,000
1/1/06 1,000 1,000 0.06 = 60 1,000
1/1/07 3,000 3,000 0.06 = 180 3,000
1/1/08 6,000 6,000 0.06 = 360 6,000
*Assuming all transactions occur at the beginning of the period.
**Since all interest earned is withdrawn, the ending account balance equals the
beginning account balance.
(c) The true rate of interest is 6 percent, the same as the stated rate of interest since the simple
interest method is being used.
61 Gitman/Joehnk Fundamentals of Investing, Ninth Edition
8. (a) Future value of $300 in twelve years at 7 percent annual compound interest:
Future value present value (future-value interest factor)
$300 (FVIF, 12 years, 7%)
$300 (2.252)*
$675.60
*From Table A.1, Appendix A.
=
=
=
=
(b) The future value at the end of 6 years of an $800 annual end-of-year deposit at 7% interest:
Future value deposit (future-value interest factor for an annuity)
FV $800 (FVIF, 6 years, 7%)
$800 (7.153)*
$5, 722.40
*From Table A.2, Appendix A.
=
=
=
=
Note: For simplicity, the problems in the rest of the chapter use the abbreviations FV, FVIF, FVIFA, PV,
PVIF, PVIFA, and k (interest rate/rate of return), n (number of years/investment period).
9. Future Value of an Investment: FVn = Investment Amount (FVIFk,n)
Investment
A FV20 = PV FVIF5%, 20 yrs.
FV20 = $200 2.653
FV20 = $530.60
Calculator solution: $530.66
B FV7 = PV FVIF8%, 7 yrs.
FV7 = $4,500 1.714
FV7 = $7,713
Calculator solution: $7,712.21
C FV10 = PV FVIF9%, 10 yrs.
FV10 = $10,000 2.367
FV10 = $23,670
Calculator solution: $23,673.64
D FV12 = PV FVIF10%, 12 yrs.
FV12 = $25,000 3.138
FV12 = $78,450
Calculator solution: $78,460.71
E FV5 = PV FVIF11%, 5 yrs.
FV5 = $37,000 1.685
FV5 = $62,345
Calculator solution: $62,347.15
10. This is a future value equation. Calculate the future value of $10,000 using a FVIF1%, 24 periods value.
$10,000 1.270 = $12,700.
Chapter 4 Return and Risk 62
11. Future Value of an Annuity Investment: FVAk,n = Annual Deposit FVIFAk,n
Investment
A FVA8%,10 yrs. = $2,500 14.487
= $36,217.50
Calc.
Soln.
= $36,216.41
B FVA12%,6 yrs. = $500 8.115
= $4,057.50
Calc.
Soln.
= $4,057.59
C FVA20%,5 yrs. = $1,000 7.442
= $7,442
Calc.
Soln.
= $7,441.60
D FVA6%,8 yrs. = $12,000 9.897
= $118,764
Calc.
Soln.
= $118,769.61
E FVA14%,30
yrs.
= $4,000
356.778
= $1,427,112
Calc.
Soln.
= $1,427,147.39
(FVIFA from Appendix A, Table A.2)
63 Gitman/Joehnk Fundamentals of Investing, Ninth Edition
12. Future value of an annuity of $1,000 for five years at 6%. $1,000 5.637 = $56,370.
13. The least you would accept for each investment is its future value at the end of six years:
(a) Future Value of an Investment: FVn = Investment Amount (FVIFk,n)
9%,6 yrs
FV $5, 000 1.677
$8, 385
=
=
Calc. Soln = $8,385.50
(b) Future Value of an Annuity Investment:
k,n k,n
9%,6 yrs.
FVA Annual Deposit FVIFA
FVA $2, 000 7.523
$15, 046
=
=
=
Calc. Soln. = $15,046.67
(c) FV of $3,000 at 9% for 6 years + FVA of $1,000 deposit at 9% at end of each of the next five
years:
(1) FV9%,6 yrs. = $3,000 1.677 (From App. A, Table A.1)
= $5,031
Calc. Soln = $5,031.30
(2) FVA9%,6 yrs. = $1,000 7.523 (From App. A, Table A.2)
= $7,523
Calc. Soln. = $7,523.33
(3) Total = $5,031 + $7,523
= $12,554
Chapter 4 Return and Risk 64
(d)
Year
End-of Year
Deposit
Number
of Years
to Compound FVIF, 9%
Future
Value
1 $900 5 1.539 $1,385.10
3 900 3 1.295 1,165.50
5 900 1 1.090 981.00
Total FV = $3,531.60
14. Present Value: PV = FVn (PVIFk,n)
Investment FV PVIF
Present
Value
Calculator
Solution
A PV12%, 4 yrs.* = $7,000 0.636 = $4,452 $4,448.63
B PV8%, 20 yrs.* = $28,000 0.215 = $6,020 $6,007.35
C PV14%, 12yrs.* = $10,000
0.208
= $2,080 $2,075.59
D PV11%, 6yrs. = $150,000
0.535
= $80,250 $80,196.13
E PV20%, 8yrs = $45,000 0.233 = $10,485 $10,465.56
PVIF from Table A.3, Appendix A.
15. This problem uses present value to solve an investment problem. The amount at which the bond will
sell today is the value today of its value at maturity (in eight years), given an interest rate of 6%:
k,n
6%,8 yrs.
PV FV (PVIF )
PV $1, 000 0.627
$627 (Calculator Solution $627.41)
=
=
= =
16. You are trying to find the present value of $1,000 in 8 years using an 8% discount rate. PVIF 8%, 8 periods
$1000 = 0.540 $1000 = $540. The price of the bond is lower at 8%. This is because it is discounted at
a higher rate (8% vs. 6%).
17. This is a present value question. Calculate the present value of $10,000 using a PVIF 3%, 10 periods value.
$10,000 0.744 = $7,440.
65 Gitman/Joehnk Fundamentals of Investing, Ninth Edition
18.
Income
Stream
End of
Year Income PVIF, 12%
Present
Value
A 1 $2,200 0.893 = $1,965
2 3,000 0.797 = 2,391
3 4,000 0.712 = 2,848
4 6,000 0.636 = 3,816
5 8,000 0.567 = 4,536
$15,556
Calculator solution = $15,555.51
B 1 $10,000 0.893 = $ 8,930
25 5,000 2.712* = 13,560
6 7,000 0.507 = 3,549
$26,039
Calculator solution = $26,034.59
C 15 $10,000 3.605** = $36,050
610 8,000 2.045*** = 16,360
$52,410
Calculator Solution = $52,411.34
* Sum of PV factors for years 25.
PVIF from Table A.3, Appendix A.
** PVIFA for 12%, 5 years
*** (PVIFA for 12%, 10 years) (PVIFA for 12%, 5 years)
PVIFA from Table A.4, Appendix A.
19. (a)
Income
Stream
End of
Year Income PVIF, 15%
Present
Value
A 1 $4,000 0.870 = $3,480
2 3,000 0.756 = 2,268
3 2,000 0.658 = 1,316
4 1,000 0.572 = 572
$7,636
Calculator solution = $7,633.48
B 1 $1,000 0.870 = $870
2 2,000 0.756 = 1,512
3 3,000 0.658 = 1,974
4 4,000 0.572 = 2,288
$6,644
Calculator solution = $6,641.41
PVIF from Table A.3, Appendix A.
(b) Income Stream A, with a present value of $7,636, is higher than Income Stream Bs present value
of $6.644 because the larger cash inflows occur in A in the early years when their present value is
greater. The smaller cash flows are received further in the future.
Chapter 4 Return and Risk 66
20. The present value of an investment with annual income streams is calculated using the formula: PVAn =
Annual returns (PVIFAk,n)
Investment Calculation Present Value Calc. Soln
A PVA7%, 3 yrs. = $1,200 2.624 = $3,148.80 $3,149.18
B PVA12%, 15
yrs
= 5,500 6.811 = 37,460.50 37,459.75
C PVA20%, 9
yrs.
= 700 4.031 = 2,821.70 2,821.68
D PVA5%, 7 yrs. = 14,000 5.786 = 81,004.00 81,009.23
E PVA10%, 5 yrs = 2,200 3.791 = 8,340.20 8,339.73
21. Find the present value of the annuity and compare it to the lump sum payment. PVIVA 8%, 20 periods
$1,000,000 = 9.818 = $9,818,000. Since this is less than $15 million, you should take the $15 million
today.
22. (a) Present value of $500 to be received in four years at an 11 percent discount rate:
11%,4 yrs.
PV FV PVIF
$500 0.659
$329.50
=
=
=
PVIF from Table A.3, Appendix A.
(b) The present value of the income from Stream A is the present value of an annuity.
9%,7 yrs.
Stream A
PVA Annual income PVIFA
PVA $80 (5.033)
$402.64
=
=
=
PVIFA from Table A.4, Appendix A.
The present value at the start of 2006 of the income from Stream B is the present value of a
mixed streamthe present value of each benefit summed.
(1) (2) (3)
(1) (2)
Year Benefit PVIF, 9% Present Value
2006 $140 0.917 $128.38
2007 120 0.842 101.04
2008 100 0.772 77.20
2009 80 0.708 56.64
2010 60 0.650 39.00
2011 40 0.596 23.84
2012 20 0.547 10.94
Total $437.04
PVIF from Table A.3, Appendix A.
Note: These streams may be used to illustrate the time value of money. Both streams have $560 in total
benefits, but the benefits in Stream A are presently worth $402.64, while the benefits in Stream B are
worth $437.04. The difference is attributable to the fact that Stream B has larger benefits or cash flows
earlier, thereby causing its present value at the 9 percent rate to be higher than Stream A.
67 Gitman/Joehnk Fundamentals of Investing, Ninth Edition
23. The analysis of Terris investment opportunities uses the formula:
FVn = PV (FVIFk,n)
Investment Calculation Decision
A $30,000 = $18,000 FVIFk,5 yrs.
k,5 yrs.
$30, 000
FVIF
$18, 000
=
1.667 = FVIFk,5 yrs.
10% < k < 11% Invest
B $3,000 = $600 FVIFk, 20 yrs.
k,20 yrs.
$3, 000
FVIF
$600
=
5 = FVIFk, 20
8% < k < 9% Forgo
C $10,000 = $3,500 FVIFk, 10 yrs.
k,10 yrs.
$10, 000
FVIF
$3, 500
=
2.857 = FVIFk, 10 yrs.
11% < k < 12% Invest
D $15,000 = $1,000 FVIFk, 40 yrs.
k,40 yrs.
$15, 000
FVIF
$1, 000
=
15 = FVIFk, 40 yrs.
7% < k < 8% Forgo
Chapter 4 Return and Risk 68
An alternative approach accurately answering the same questions would be the calculation of the
present value of cash inflows and comparing the results to the investments cost.
Investment A
$30,000 0.621 = $18,630 (using PVIF10%,5 years)
Cost of Investment = $18,000
Return exceeds costInvest
Investment B
$3,000 0.149 = $447 (using PVIF10%,20 years)
Cost of Investment = $600
Cost exceeds returnforgo
Investment C
$10,000 0.386 = $3,860 (using PVIF10%,10 years)
Cost of Investment = $3,500
Return exceeds costInvest
Investment D
$15,000 0.022 = $330 (using PVIF10%,40 years)
Cost of Investment = $18,000
Cost exceeds returnforgo
24.
Income
Stream
End of
Year Income PVIF, 17%, n
Present
Value
A 1 $2,500 0.855 = $2,137.50
2 3,500 0.731 = 2,558.50
3 4,500 0.624 = 2,808.00
4 5,000 0.534 = 2,670.00
5 5,500 0.456 = 2,508.00
Total PV = $12,682.00
Calculator solution = $12,680.08
B 1 $4,000 0.855 = $3,420.00
2 3,500 0.731 = 2,558.50
3 3,000 0.624 = 1,872.00
4 1,000 0.534 = 534.00
5 500 0.456 = 228.00
Total PV = $8,612.50
Calculator solution = $8,610.42
PVIF from Table A.3, Appendix A.
69 Gitman/Joehnk Fundamentals of Investing, Ninth Edition
At 17% required return, the present value of the income from Investment A, $12,682, is less than
the $13,000 purchase price. Investment Bs present value is $8,612.50, above the purchase price.
Therefore, Kent should purchase Investment B.
25. $15,000 = PVIFA1%, 50 payments
$15,000 = 39.196
$15,000/39.196 = $382.69
26. Balance is the present value of the payments at 12%. Payments are $382.69 PVIFA1%, 40 periods $382.69
= 32.835 $382.69 = $12,565.62
27. (a) Using the notation given in the chapter, the risk-free rate of interest for both Investments is:
*
R r IP
3% 5%
8%
= +
= +
=
(b) The required returns for each investment are calculated as follows:
r1 = r
*
+ IP + RPi or RF + RPi
rA = 3% + 5% + 3% 8% + 3%
= 11%
rB = 3% + 5% + 5% 8% + 5%
= 13%
28. The risk-free rate = real rate + expected inflation premium. If the expected inflation premium
increases by 1%, then the risk-free rate will increase by 1% to 8%.
Chapter 4 Return and Risk 70
29. Holding period return (HPR) =
Current income Ending price Beginning price
Beginning price
+
X
Y
$1.00 $1.20 $0 $2.30 $29.00 $30.00 $3.50
HPR
$30.00 $30.00
11.67%
$0 $0 $0 $2.00 $56.00 $50.00 $8.00
HPR
50.00 $50.00
16.0%
+ + + +
= =
=
+ + + +
= =
=
If the investments are held beyond a year, the capital gain (loss) component would not be realized
and would likely change. Assuming they are of equal risk, Investment Y would be preferred since it
offers the higher return (16.0% for Y versus 11.67% for X).
30. HPR = (current income over the period + capital gains)/beginning investment value
First investment: ($1.00 + 2.00) / $25 = 12%. Since this is a six-month investment, the annualized
return is two times the HPR (12/6), or 24%.
Second investment: ($2.40 + $3.00) / $27 = 20%.
The first investment provides the higher annualized return.
31. HPR = ($50 + ($1,000 $950))/$950 = $100/$950 = 10.5%
32. The present value is $5,000. The value in 10 years will be $9,000.
(a) Using present value, the yield is calculated as:
x%,10 yrs.
x%,10 yrs.
$9, 000 PVIF $5, 000
$5, 000
PVIF
$9, 000
0.556
=
=
=
From Table A.3, Appendix A, at 10 years the PVIF of 6% is 0.558, which is very close to 0.556.
The yield, then, is estimated to be 6%.
(b) If a minimum return of 9% is required, this investment would not be recommended because it
only yields about 6%.
33. Using PFIV of 4%:
$65 0.962 = $62.53
$70 0.925 = $64.75
$70 0.889 = $62.23
$7,965 0.855 =
$6,810.08
$6,999.59
71 Gitman/Joehnk Fundamentals of Investing, Ninth Edition
34. Interest on the investment in year five
(10,000 FVIF8%, 5 years) $10,000 = ($10,000 1.469) $10,000 = $4,690
Yield:
$10,000 = (PVIF?%, 5 years $4690) + (PVIF ?%, 6 years $14,500)
Using 12%:
(0.567 $4690) + (0.507 $14,500) = $2,659.23 + $7,351.50 = $10,010.73
Since this total is close to $10,000, the yield is approximately 12%. (Since the value is above
$10,000, the true yield is slightly higher than 12%).
35.
(1) (2) (3) (4) (5)
Initial Future (1) (2) Approximate
Investmen
t
Investment Value Years Discount Rate Yield*
A $1,000 $1,200 5 0.833 4% (0.822)
B 10,000 20,000 7 0.500 10% (0.513)
C 400 2,000 20 0.200 8% (0.215)
D 3,000 4,000 6 0.750 5% (0.747)
E 5,500 25,000 30 0.220 5% (0.231)
* From Table A.3, Appendix A.
36. (a)
Initial Investment $2, 500
0.417
Future Value $6, 000
= =
The closest PVIF for 8 years is 0.404, for a yield of 12%.
(b) Rosemary should make the proposed investment because the yield, in both the present value and
approximate yield calculations, is greater than her 10% required return.
37. The yield for these investments is the discount rate that results in the stream of income equaling the
initial investment.
Investment A: Using the present value of an annuity formula:
k%,5yrs.
k%,5 yrs.
k%,5 yrs.
k%,5 yrs.
PVA Annual deposit PVIFA
$8, 500 $2, 500 PVIFA
$8, 500
PVIFA
$2, 500
3.4 PVIFA
=
=
=
=
Looking at Table A.4, Appendix A, the closest factor for five years occurs at 14% (3.433); therefore,
this investment yields about 14%.
Chapter 4 Return and Risk 72
Investment B: It is necessary to try several different discount rates to determine the yield for
Investment B. One way to estimate a starting point is to use the average annual income in the formula
used in Part A and adjusting it based on whether the larger cash flows are received in the earlier or
later years. The Internal Rate of Return (IRR) function on a business calculator makes the task easier.
k%,5yrs.
k%,5 yrs.
k%,5 yrs.
k%,5 yrs.
PVA Annual deposit PVIFA
$9, 500 $3, 000 PVIFA
$9, 500
PVIFA
$3, 000
3.167 PVIFA
=
=
=
=
The closest interest rate to 3.167 in Table A.4, Appendix A, is 17%. Because the larger cash flows are
received in the later years, 16% is a good starting point.
(1) (2) (3) (4) (5)
(1) (4)
Year Income PVIF, 16% PV at 16% PVIF, 15% PV at 15%
1 $2,000 0.862 $1,724.00 0.870 $1,740.00
2 2,500 0.743 1,857.50 0.756 1,890.00
3 3,000 0.641 1,923.00 0.658 1,974.00
4 3,500 0.552 1,932.00 0.572 2,002.00
5 4,000 0.476 1,904.00 0.497 1,988.00
PV of Income = $9,340.50 $9,594.00
Calculator Solution = $9,341.49 $9,591.88
The discount rate that results in a present value closest to $9,500 is 15%.
Calculator solution for IRR = 15.36
38. (a) Using the same technique as shown in the prior question, we find that 7% is a possible discount
rate. Because the larger cash flows occur in the early years, 8% is a good starting point.
(1) (2) (3) (4) (5)
(1) (2) (1) (4)
Year Income 8% PVIF PV at 8% 9% PVIF PV at 9%
1 $6,000 0.926 $5,556 0.917 $5,502
2 3,000 0.857 2,571 0.842 2,526
3 5,000 0.794 3,970 0.772 3,860
4 2,000 0.735 1,470 0.708 1,416
5 1,000 0.681 681 0.650 650
PV of Income = $14,248 $13,954
The discount rate that results in a present value closest to $14,000 is 9%.
Calculator solution for IRR = 8.85%.
(b) Elliott should not make the proposed investment because the yield in the present value
calculation is less that the 11% required return.
73 Gitman/Joehnk Fundamentals of Investing, Ninth Edition
39.
(4) (5)
End of (1) (2) (3) (1) (2) (1) (4)
Year Income 10% PVIF PV at 10% 11% PVIF PV at 11%
$0 1 $1000 1 $1000
2006 140 0.909 127.26 0.901 126.14
2007 120 0.826 99.12 0.812 97.44
2008 100 0.751 75.1 0.731 73.10
2009 80 0.683 54.64 0.659 52.72
2010 60 0.621 37.26 0.593 35.58
2011 40 0.564 22.56 0.535 21.4
2012 1220 0.513 625.86 0.482 588.04
PV of Income = $41.80 $5.58
The Yield is very close to 11% on this investment.
Since the yield of 11% is greater than the minimum required return of 9.0%, the investment is
recommended. This project would result in positive Net Present Value to the investor.
40. Growth rates are calculated using the present value formula PV = FVn PVIFk,n
Investment
A n = 2005 1991 = 4
PV = FV4 PVIFk,4 yrs.
$5.00 = $8.00 PVIFk,4 yrs
0.625 = PVIFk,4yrs
12% < k < 13%
Calculator Solution = 12.47%
B n = 2005 1996 = 9
PV = FV9 PVIFk,9 yrs.
$1.50 = $2.28 PVIFk,9 yrs.
0.658 = PVIFk,9yrs.
4% < k < 5%
Calculator solution = 4.76%
C n = 2005 1999 = 6
PV = FV6 PVIFk,6 yrs.
$2.50 = $2.90 PVIFk,6 yrs.
0.862 = PVIFk,6yrs.
2% < k < 3%
Calculator solution = 2.50%
41. 2004 1997 = 7 years
$1 FVIF ?%, 7 years = $2.21
FVIF = $2.21/$1 = 2.21
FVIF 12%, 7 years = 2.211, so the yield is about 12%
Chapter 4 Return and Risk 74
42. 2004 2000 = 4 years
350 FVIF ?%, 4 years, 441.7
FVIF ?%, 4 years = 441.7/350 = 1.262
FVIF 6%, 4 years = 1.262, so the yield is about 6%
43. (a) Investment A, with returns that vary widelyfrom 1% to 26%appears to be more risky than
Investment B, whose returns vary from 8% to 16%.
(b)
n
2
i 1
s (r r)
=
=

Standard deviation
CV
average return
=
Investment A:
(1) (2) (3) (4)
Return Average (1) (2) (3)
2
Year r i Return, r ri r (ri r)
2
2001 19% 12% 7% 49%
2002 1 12 11 121
2003 10 12 2 4
2004 26 12 14 196
2005 4 12 8 64
434
A
434
S 108.5 10.42%
10.42%
CV 0.87
12.00%
= = =
5 1
= =
Investment B:
(1) (2) (3) (4)
Year Return Average (1) (2) (3)
2
r i Return, r ri r (ri r)
2
2001 8% 12% 4% 16%
2002 10 12 2 4
2003 12 12 0 0
2004 14 12 2 4
2005 16 12 4 16
40
A
40
S 10 3.16%
3.16%
CV 0.26
12.00%
= = =
5 1
= =
75 Gitman/Joehnk Fundamentals of Investing, Ninth Edition
(c) Investment A, with a standard deviation of 10.42, is considerably more risky than Investment B,
whose standard deviation is 3.16. This confirms the conclusions reached in Part A.
(d) Because the real benefit of calculating the coefficient or variation is in comparing investments
that have different average returns, the standard deviation is not improved upon.
44. Since Investment A returns are much more variable, Investment A should carry a higher risk
premium. Investment As required return is 14%.
.9 Solutions to Case Problems
Case 4.1 Solomons Decision
This case introduces the student to the concepts of opportunity cost and required rate of return. It further
requires students to compute present values and select investments using the reasonable return approach
discussed in the chapter.
(a) Using the present value technique for the equally risky projects, we select the one with the highest
present value (net of the purchase price of the investment$1,050 for both investments) if the present
value exceeds the investment cost.
Present value of A: This is the present value of a nine-year $150 annuity plus 1 payment in year 10 of
$1,150, so we will use the present-value interest factor for an annuity from Table A.4, Appendix A,
and the present-value interest factor for a dollar from Table A.3.
A 12%,9 yrs. 12%,10 yrs.
PV $150 PVIFA $1,150 PVIF
$150 5.328 $1,150 0.322
$799.20 $370.30
$1,169.50
= +
= +
= +
=
Present value of B: This is the present value of a mixed stream, so we use the present-value interest
factors for one dollar from Table A.3.
(1) (2) (3)
(1) (2)
Year Benefit PVIF (12%) Present Value
2006 $100 0.893 $89.30
2007 150 0.797 119.55
2008 200 0.712 142.40
2009 250 0.636 159.00
2010 300 0.567 170.10
2011 350 0.507 177.45
2012 300 0.452 135.60
2013 250 0.404 101.00
2014 200 0.361 72.20
2015 150 0.322 48.30
Total PV = $1,214.90
Each investment is acceptable because its present value is greater than its initial cost of $1,050.
However, the present value of B is higher than A, and since both cost $1,050, B would be the
preferred investment. If both are equally risky, B has a higher return ($1,214.90) for its level of risk
than A ($1,169.50).
Chapter 4 Return and Risk 76
(b) For projects of unequal risk, we must evaluate each at its required rate of return (adjusted for its level
of risk). Using a 16 percent interest factor (from Table A.3, Appendix A), the present value of
Investment B is:
(1) (2) (3)
(1) (2)
Year Benefit PVIF (16%) Present Value
2006 $100 0.862 $86.20
2007 150 0.743 111.45
2008 200 0.641 128.20
2009 250 0.552 138.00
2010 300 0.476 142.80
2011 350 0.410 143.50
2012 300 0.354 106.20
2013 250 0.305 76.25
2014 200 0.263 52.60
2015 150 0.227 34.05
Total PV = $1,019.25
Since $1,019.25, the present value of investment B, does not remain greater than its cost ($1,050), it is
no longer an acceptable investment. Investment A is the only one of the two earning a reasonable (i.e.,
acceptable) return.
(c) Since Investment A was acceptable (had a positive present value) at a discount rate of 12 percent, its
yield must be more than 12 percent. Investment B was acceptable at a discount rate of 12 percent, so
its yield is also greater than 12%. However, Investment Bs yield is between 12 and 16 percent. The
present value of B at 12 percent equaled $1,214.90, and at 16 percent it was $1,019.25. Since the
present value at 16 percent is closer to the cost than the present value at 12 percent, the actual yield is
closer to 16 percent. It appears to be about 15.25 percent. (The actual yield computed using a
calculator is 15.31 percent.)
(d) Investment A:
Present value technique:
Step 1: Find the present value of $150 income for 9 years using the present value of an annuity
formula.
Step 2: Find the PV of $1,150 in year 10.
Step 3: Add the two amounts to get the total PV. Try different discount rates to determine the yield
(IRR). Because we know from question 1 that the present value at 12% is $1,196.50, just above the
initial investment amount, start with 13%:

13%,9 yrs. 13%, 9 yrs.
13%,10 yrs. 13%, 10 yrs.
Step 1. PVA Annual income PVIFA
$150 5.132
$769.80
Step 2. PV Income in Year 10 PVIF
$1,150 0.295
$339.25
Step 3. Total PV $769.80 $339.25 $1,109.05
=
=
=
+
=
=
=
= + =
77 Gitman/Joehnk Fundamentals of Investing, Ninth Edition
Try 14%:

14%, 9 yrs. 14%, 9 yrs.
14%, 10 yrs. 14%, 10 yrs.
Step 1. PVA Annual income PVIFA
$150 4.946
$741.90
Step 2. PV Income in Year 10 PVIF
$1,150 0.270
$310.50
Step 3. Total PV $741.90 $310.50 $1, 052.40
=
=
=
+
=
=
=
= + =
Yield = 14%
Investment B: Because the present value of the income from Investment B is $1,019.25 at 16%
(Question 2), try a 15% discount rate:
(1) (2) (3)
(1) (2)
Year Benefit PVIF (15%) Present Value
2006 $100 0.870 $87.00
2007 150 0.756 113.40
2008 200 0.658 131.60
2009 250 0.572 143.00
2010 300 0.497 149.10
2011 350 0.432 151.20
2012 300 0.376 112.80
2013 250 0.327 81.75
2014 200 0.284 56.80
2015 150 0.247 37.05
Total PV = $1,063.70
Yield is 15% (Calculator solution: 15.31%)
(e) Because Investment A is acceptable at a 12 percent discount rate while Investment B is unacceptable
at a 16 percent discount rate, Investment A is recommended. Although it seems as if investment B is
being penalized with a higher discount rate, due to its greater risk it must earn a 16 percent yield to be
acceptable.
(f) His initial investment of $50 would have grown to $81.45 at the end of the ten years assuming that he
makes no withdrawals from his savings account. This is calculated using a future-value interest factor
from Table A.1, as illustrated below:
FV5%, 10yrs. = $50 1.629 = $81.45
Chapter 4 Return and Risk 78
Case 4.2 The Risk-Return Tradeoff: Molly ORourkes Stock Purchase Decision
The title of this case clearly states its objective. It requires students to review and apply the concept of the
risk-return trade-off.
(a)
Current Income Ending Price Beginning Price
HPR
Beginning Price
+
=
HPR for Stock X:
(1) (2) (3) (4)
(2) (3)
(5)
[(1) + (4)]/(3)
Year
Current
Income
Ending
Price
Beginning
Price
Capital
Gain HPR
1996 $1.00 $22.00 $20.00 $2.00 15.00%
1997 1.50 21.00 22.00 1.00 2.27
1998 1.40 24.00 21.00 3.00 20.95
1999 1.70 22.00 24.00 2.00 1.25
2000 1.90 23.00 22.00 1.00 13.18
2001 1.60 26.00 23.00 3.00 20.00
2002 1.70 25.00 26.00 1.00 2.69
2003 2.00 24.00 25.00 1.00 4.00
2004 2.10 27.00 24.00 3.00 21.25
2005 2.20 30.00 27.00 3.00 19.26
Average (expected) HPR for stock X = 11.74%
HPR for Stock Y:
(1) (2) (3) (4)
(2) (3)
(5)
[(1) + (4)]/(3)
Year
Current
Income
Ending
Price
Beginning
Price
Capital
Gain HPR
1996 $1.50 $20.00 $20.00 $0.00 7.50%
1997 1.60 20.00 20.00 0.00 8.00
1998 1.70 21.00 20.00 1.00 13.50
1999 1.80 21.00 21.00 0.00 8.57
2000 1.90 22.00 21.00 1.00 13.81
2001 2.00 23.00 22.00 1.00 13.64
2002 2.10 23.00 23.00 0.00 9.13
2003 2.20 24.00 23.00 1.00 13.91
2004 2.30 25.00 24.00 1.00 13.75
2005 2.40 25.00 25.00 0.00 9.60
Average (expected) HPR for stock Y = 11.14%
79 Gitman/Joehnk Fundamentals of Investing, Ninth Edition
(b)
2
n
i
i 1
(r r)
s
N 1
=

Investment X:
(1) (2) (3) (4)
Return Average (1) (2) (3)
2
Year ri Return, r ri r (ri r)
2
1996 15.00% 11.74% 3.26% 10.63%
1997 2.27 11.74 9.47 89.68
1998 0.95 11.74 9.21 84.82
1999 1.25 11.74 12.99 168.74
2000 13.18 11.74 1.44 2.07
2001 20.00 11.74 8.26 68.23
2002 2.69 11.74 9.05 81.90
2003 4.00 11.74 7.74 59.91
2004 21.25 11.74 9.51 90.44
2005 19.26 11.74 7.52 56.55
712.97
X
712.97
s 79.22 8.9%
10 1
= = =

Coefficient of variation = 8.9%/11.74% = 0.76


Investment Y:
(1) (2) (3) (4)
Return Average (1) (2) (3)
2
Year ri Return, r ri r (ri r)
2
1996 7.50% 11.14% 3.64% 13.25%
1997 8.00 11.14 3.14 9.86
1998 13.50 11.14 2.36 5.57
1999 8.57 11.14 2.57 6.60
2000 13.81 11.14 2.67 7.13
2001 13.64 11.14 2.50 6.25
2002 9.13 11.14 2.01 4.04
2003 13.91 11.14 2.77 7.67
2004 13.75 11.14 2.61 6.81
2005 9.60 11.14 1.54 2.37
Y
69.55
s 7.73 2.78%
10 1
= = =

Coefficient of variation = 2.78%/11.14% = 0.25


Chapter 4 Return and Risk 80
(c) and (d)
Summary Statistics:
Investment X Investment Y
Expected Return 11.74% 11.14%
Standard Deviation 8.82 2.78
Coefficient of Variation 0.76 0.25
Comparing the expected returns calculated in question 1, Stock X provides a return of 11.74 percent,
which is only slightly above the expected return of Y (=11.14 percent). Whether the higher return on
Stock X is sufficient to compensate for the higher risk would be determined by the price of risk in
the financial markets.
As can be seen, Standard Deviation and Coefficient of variation of Stock X is higher than the
corresponding values of stock Y. This might be a signal to prefer stock Y. But these numbers have to
be interpreted with caution as one of the above stocks is to be added to a well diversified portfolio.
This part of the case problem anticipates the use of beta and CAPM, which will be covered in the next
chapter on modern portfolio concepts. The calculation of required return provides an objective
approach to assess the investment risk.
Using the capital asset pricing model, the required return on each stock is as follows:
Capital Asset Pricing Model: ri = Rf + [bI (rm RF)]
Investmen
t
r
Rf + [bI (rm RF)]
A 11.8% = 7% + [1.6 (10% 7%)
B 10.3% = 7% + [1.1 (10% 7%)
From the calculations in question 1, Stock X has an expected return of 11.74% and a required return of
11.8%. On the other hand, Stock Y has an expected return of 11.14% and a required return of only
10.3%.
So while we concluded that it would be difficult to make a choice between X and Y because the
additional return on X may or may not provide the needed compensation for the extra risk, we see that
by calculating a required rate of return, it is easy to reject X and invest in Y. The required return on
Stock X is 11.8%, which is higher than expected return (11.74%); therefore Stock X is unattractive.
Using the same logic, Stock Y is a better investment vehicle.
Clearly, Molly is better off using beta rather than a strictly subjective approach to assess investment
risk. The use of beta and CAPM allows risk to be quantified and converted into a required return that
can be compared to the expected return to draw a definitive conclusion about investment acceptability.
The student will meet these concepts in the next chapter.