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Complete Solutions For Chapter 05

|| Risk & Return ||

We are providing solutions of Question 01 – 10 here, Solutions to Self-Correction


Problems are given at the end of chapter 05, moreover we have these solutions too
but complete solutions regarding to Problems Questions are being provided @ BBA
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Problems Solutions : Question 01 – 10

1 )

b) There is a 30 percent probability that the actual return will be zero (prob.
E(R) = 0 is 20%) or less (prob. E(R) < is 10%). Also, by inspection we see that the
distribution is skewed to the left.

2) a) For a return that will be zero or less, standardizing the

deviation from the expected value of return we obtain (0% -

20%)/15% = -1.333 standard deviations. Turning to Table V at

the back of the book, 1.333 falls between standard deviations of

1.30 and 1.35. These standard deviations correspond to areas

under the curve of .0968 and .0885 respectively. This means that
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there is approximately a 9% probability that actual return will be

zero or less.(Interpolating for 1.333, we find the probability to be

9.13%.)

b) 10 percent: Standardized deviation = (10% - 20%)/15% =

-0.667. Probability of 10 percent or less

return = (approx.) 25 percent. Probability of 10

percent or more return = 100% - 25% = 75 percent.

20 percent: 50 percent probability of return being above 20 percent.

30 percent: Standardized deviation = (30% - 20%)/15%


=+0.667. Probability of 30 percent or
more return = (approx.) 25 percent.

40 percent: Standardized deviation = (40% - 20%)/15%


=+1.333.Probability of 40 percent or more return =
(approx.) 9 percent -- (i.e., the same percent as in part (a)).

50 percent: Standardized deviation = (50% - 20%)/15%


=+2.00.Probability of 50 percent or more return =2.28
percent.
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3) As the graph will be drawn by hand with the characteristic line fitted

by eye, they will not all be the same. However, students should reach the same

general conclusions.

( Copyrights : Pearson Education 2005 .)

The beta is approximately 0.5. This indicates that excess returns for the

stock fluctuate less than excess returns for the market portfolio. The stock

has much less systematic risk than the market as a whole. It would be a

defensive investment.
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4) Req. (RA) = .07 + (.13 - .07) (1.5) = .16

Req. (RB) = .07 + (.13 - .07) (1.0) = .13

Req. (RC) = .07 + (.13 - .07) (0.6) = .106

Req. (RD) = .07 + (.13 - .07) (2.0) = .19

Req. (RE) = .07 + (.13 - .07) (1.3) = .148

The relationship between required return and beta should be stressed.

5 ) Expected return = .07 + (.12 - .07)(1.67) = .1538, or 15.38%


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6)
Perhaps the best way to visualize the problem is to plot expected returns

against beta. This is done below. A security market line is then drawn from the

risk-free rate through the expected return for the market portfolio which has a

beta of 1.0

( Copyrghts : Pearson Education 2005 )

The (a) panel, for a 10% risk-free rate and a 15% market return, indicates

that stocks 1 and 2 are undervalued while stock 4 is overvalued.Stock 3 is


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priced so that its expected return exactly equals the return required by

the market; it is neither overpriced nor underpriced.

The (b) panel, for a 12% risk-free rate and a 16% market return, shows all

of the stocks overvalued. It is important to stress that the relationships

are expected ones. Also, with a change in the risk-free rate, the betas

are likely to change.

7)
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8) Required return = .10 + (.15 - .10)(1.08)

= .10 + .054 = .154 or 15.4 percent

Assuming that the perpetual dividend growth model is appropriate, we


get

V = D1/(ke - g) = $2/(.154 - .11) = $2/.044 = $45.45


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9)

b) Expected portfolio return = .08 + (.14 - .08)(1.115)

= .08 + .0669 = .1469 or 14.69%

10 )
a) Required return = .10 + (.14 - .06)(1.50)

= .10 + .12 = .26 or 26 percent Assuming that the

constant dividend growth model is appropriate, we get

V = D1/(ke - g) = $3.40/(.26 - .06) = $3.40/.20 = $17.00


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b) Since the common stock is currently selling for $30 per share in

the marketplace, while we value it at only $17 per share, the

company’s common stock appears to be “overpriced.” Paying

$30 per share for the stock would likely result in our

receiving a rate of return less than that required based on the

stock’s systematic risk.

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