FEDERAL URDU UNIVERSITY OF ART’S SCINCES AND

TECHNOLOGY OF ISLAMABAD

Student name: Muqaddas Zulfiqar

Father name: Zulfiqar Ali
MIS ID: 30101
Subject: Introduction To Business Finance
Submitted To: Miss Mehwish Aziz Khan

Assignment # 7

Question 1
Suppose that your estimates of the possible one-year returns from investing in
the common stock of the A. A. Eye-Eye Corporation were as follows:

Probability of occurrence 0.1 0.2 0.4 0.2 0.1

Possible return −10% 5% 20% 35% 50%

What are the expected return and standard deviation?

Answer
STEP 1
Calculation of expected return:
Calculation of expected return= possible return × probability of occurance
Calculation of expected return=[0.1 × 10%]+[0.2 × 5%]+[0.4 × 20%]+[0.2 ×
35%]+[0.1 × 50%]
Calculation of expected return= 20%
STEP 2
Calculation of standard deviation:
Return Deviation dx^2 Probability (p) Pdx^2
from mean
(X-mean)dx
-10% -30 900 0.1 90
5% -15 225 0.2 45
20% 0 0 0.4 0
35% 15 225 0.2 45
50% 30 900 0.1 90
100 €Pdx^2= 270

Mean= €X/n
Mean= 100/5
Mean= 20

Standard deviation (SD)= √(€pdx^2)

Standard deviation (SD)=√270
Standard deviation (SD)=16.43
Question 2
Sorbond Industries has a beta of 1.45. The risk-free rate is 8 percent and the
expected return on the market portfolio is 13 percent. The company currently
pays a dividend of $2 a share, and investors expect it to experience a growth in
dividends of 10 percent per annum for many years to come.
a. What is the stock’s required rate of return according to the CAPM?
b. What is the stock’s present market price per share, assuming this required
return?

Answer

STEP 1
Following information are provided in the question:
Beta of Sorbond = 1.45
Risk free rate = 8%
Expected return on the market = 13%
Dividend per share = $2
Growth in dividend = 10% per annum
STEP 2
a. Required rate of return according to CAPM:
CAPM or (Capital Asset Pricing Model) = Risk Free Rate + (Beta * (Expected
market return - Risk Free Rate))
CAPM or (Capital Asset Pricing Model) = 8% + (1.45*(13%-8%))
CAPM or (Capital Asset Pricing Model) = 8%+7.25%
CAPM or (Capital Asset Pricing Model) = 15.25%
Required rate of return according to CAPM = 15.25%
STEP 3
b. Present market price per share:
Under dividend discount model, P = D / (r - g)
Where P = price of the share;
D = Dividend per share = $2
r = required rate of return = 15.25%
g = growth rate = 10%
Price of the share = $2/(15.25%-10%)
Price of the share= $38.10
Present market price per share = $38.10

STEP 4
c. Required return and market price if Beta were 0.80
Required return using CAPM = Risk Free Rate + (Beta * (Expected market return -
Risk Free Rate))
Required return using CAPM = 8% + (0.80*(13%-8%))
Required return using CAPM = 8%+4%
Required return using CAPM = 12%
Thus, required rate becomes 12% if the beta were 0.80

STEP 5
Price of the share = Under dividend discount model, P = D / (r - g)
Price of the share = $2/(12%-10%)
Price of the share = $2/2%
Price of the share = $100
Present market price per share if beta is 0.80 = $100
Question 3
Calculating Returns and Standard Deviations Based on the following
information, calculate the expected return and standard deviation:

Answer

STEP 1
The given data is sumarized as;
State of economy Probability of state of Rate of return if state
economy occurs
Depression 0.10 -0.045
Recession 0.25 0.044
Normal 0.45 0.120
Boom 0.20 0.207

STEP 2
Calculation of Expected return:
Expected return = XR₁ + X₂ R₁ +X¸Ñ +X₂ R₁
Expected return= 0.10(-0.045)+0.25(0.044) +0.45(0.120) +0.20(0.207)
Expected return= 0.1019
Expected return = 10.19%

STEP 3
Calculation of Standard Deviation:
To calculate standard deviation the variance has to be found out. To calculate
Variance Squared deviation for expected return is to be determined.
Formula
SD= SD(portfolio) = √Var(portfolio)
Standard.deviation=0.10(-0.045-0.1019)²+0.25(0.044-0.1019)²
+0.45(0.120−0.1019)² +0.20(0.207-0.1019)
SD=0.00535
SD = √0.00535
SD = 0.0731
Standard Deviation = 7.31%

Question 4
Calculating Returns and Standard Deviations Based on the following
information, calculate the expected return and standard deviation for the two
stocks:
Answer

STEP 1
Calculating Returns and Standard Deviations - [LO1] :
State of Prob Retu Px P(x- Return Py P(y-yi)^2
Eco (p) rn xi)^2 on
from B(y)%
A(x)
%
Recess 0.15 6 0.9 0.41 -20 -3 421.153
Normal 0.65 7 4.55 0.275 13 8.45 0.59
Boom 0.20 11 2.2 2.245 33 6.6 87.78
€px= 2.93 €py=1 509.524
7.65 2.05
Question 5
Using CAPM A stock has a beta of 1.25, the expected return on the market is
12 percent, and the risk-free rate is 5 percent. What must the expected return
on this stock be?

Answer

STEP 1
The given data is summarized as:
Beta of stock = 1.25
Expected Return = 12%
Risk-free rate = 5%

STEP 2
Formula of CAPM is:
E(Ri)=Rf,+Bi, (Rm-Ri)
Where E (Ri) = Expected return on the stock
Rf= Risk Free Rate
Bi= Stock's Beta
E (RM) = Expected return on the market portfolio
E(Ri) = 0.05+1.25(0.12 -0.05)
E(Ri) = 0.05 +1.25(0.07)
E(Ri) = 0.1375
Expected Return on stock = 13.75%
Question 6
Using CAPM A stock has an expected return of 14.2 percent, the risk-free rate
is 4 percent, and the market risk premium is 7 percent. What must the beta of
this stock be?

Answer:

STEP 1
The given data is summarized as.
Expected rate of return of the stock = 14.2%
Risk-free rate = 6%
Market risk premium = 7%

STEP 2
Calculation of beta of stock:
Market risk premium is the Expected return of the market minus the Risk-free rate.
Formula of CAPM
E(Ri)=Rf+Bi (RM-Rf)
Where E (Ri) = Expected return on the stock
RF = Risk Free Rate
B = Stock's Beta
E (RM) = Expected return on the market portfolio
0.142 0.04 +B(0.07)
B = 1.46
Beta of the stock = 1.46
Question 7
Using CAPM A stock has an expected return of 10.5 percent, its beta is .73,
and the risk-free rate is 5.5 percent. What must the expected return on the
market be?

Answer

STEP 1
The given data is summarized as:
Expected return of the stock = 10.5%
Risk-free return = 5.5%
Beta of the stock = 0.73

STEP 2
Calculation of the Expected return of the market
Formula of CAPM:
E(Ri) = RF+Bi (RM-RE)
Where E (Ri) = Expected return on the stock
RF = Risk Free Rate
B= Stock's Beta
E (RM) = Expected return on the market portfolio
0.105= 0.055 +0.73(RM -0.055)
RM= 0.09015+ 0.73
RM = 0.12349
Expected return on the market = 12.35%

Question 8
Using CAPM A stock has an expected return of 16.2 percent, a beta of 1.75,
and the expected return on the market is 11 percent. What must the risk-free
rate be?

Answer

STEP 1:
The given data is summarized as
Expected return of the stock = 16.2%
Beta of the stock = 1.75
Expected return of the market = 11%

STEP 2:
Calculation of Risk free rate:
Formula of CAPM:

E(Ri)= Rf+Bi(E(RM)-Rf)
Where E (R₁ ) = Expected return on the stock
RF= Risk Free Rate
B = Stock's Beta
E (RM)= Expected return on the market portfolio
0.162= Rf +1.75(0.11-Rf)
0.162 = Rf +0.1925-1.75Rf
RF = 0.04066
Risk-free rate = 4.07%