Jimenez, Angel Kaye BSA-2 ACC 216 9:45-11:45

Evaluating Risk and Return

Requirement #1: Calculate Each Stock’s Coefficient Variation

Stock Expected Standard Stocks Co-efficient
Return Deviation Variation
𝒓̂ σ CV = σ / 𝒓̂
X 10% 35% 3.5
Y 12.5% 15% 1.2

Requirement #2: Which stock is riskier for a diversified investor?

Beta is the basis for a diversified investor to measure the risk since
beta will tell how sensitive your investment to risk. In the given table Stock X has
0.9 Beta while Stock Y has 1.2 Beta. It was discussed that the higher beta the
higher the risk. Therefore, since Stock Y has a higher beta than Stock X. Stock Y
is riskier for a diversified investor.

Requirement #3: Calculate each stock’s required rate of return

Stock rRF RPM Beta Required Rate of
Return
ri = rRF + (RPM) bi
X 6% 5% 0.9 10.5%
Y 6% 5% 1.2 12%
Requirement #4: On the basis of two stocks’ expected and required
returns, which stock would be more attractive to a diversified investor?

Stock Expected Rate of Required Rate of

Return Return
X 10% 10.5% Overvalued
Y 12.5% 12% Undervalued

For a diversified investor, comparing the two stock, he/she will prefer Stock
Y. Stock Y would be the most attractive stock because its expected rate of return
which is 12.5 % is greater than the required rate of return of 12%.

Requirement #5: Calculate the required return of a portfolio that has $7,500
invested in Stock X and $ 2,500 invested in Stock Y.
𝟕𝟓𝟎𝟎 𝟐𝟓𝟎𝟎
𝒃𝒑 = ( ) (𝟎. 𝟗) + ( ) (𝟏. 𝟐)
𝟏𝟎, 𝟎𝟎𝟎 𝟏𝟎, 𝟎𝟎𝟎
𝒃𝒑 = 𝟎. 𝟔𝟕𝟓 + 𝟎. 𝟑

𝒃𝒑 = 𝟎. 𝟗𝟕𝟓

𝒓𝒑 = 𝟔% + 𝟓% (𝟎. 𝟗𝟕𝟓)

𝒓𝒑 = 𝟏𝟎. 𝟖𝟕𝟓
Requirement #6: If the market risk premium is increased to 6%, which of
the two stocks would have a larger increase in its required rate of return?
Stock rRF RPM Beta Required Rate of
Return
ri = rRF + (RPM) bi
X 6% 6% 0.9 11.4%
Y 6% 6% 1.2 13.2%

Stock Required Rate of Required Rate of Difference

Return w/ 5% RPM Return w/ 6% RPM

X 10.5% 11.4% 0.9

Y 12% 13.2% 1.2
 If the market risk premium is increased to 6%, Stock Y would have a
larger increase in its required rate of return compared to Stock X. Wherein
it has a 1.2 increase from the 5% market risk premium.