Camingawan, Micon D.

BSMA 2B

1. PROBLEM 8-5
BETA AND REQUIRED RATES OF RETURN: The stock of Orange
Inc. has a required rate of return of 14%, the required return on the market is
11% and the risk-free rate is 5%.
a. What is the market risk premium?
ANSWER: Market Risk Premium = 6%

FORMULA:
RETURN = 11%
RISK-FREE RATE = 5%

Risk Premium = 11% – 5%

Market Risk Premium = 6%

b. What is the stock’s beta?

ANSWER: BETA = 1.5

FORMULA:
r = 14%
rRF = 5%
RPM = 6%.

r = rRF + (rM – rRF) b

14% = 5% + b (6%)
BETA = 1.5

c. If the required return on the market increased to 12%, what would

happen to the stock’s required rate of return? Assume that the risk-
free rate and beta remain unchanged.
ANSWER: Required Rate of Return = 15.5%

FORMULA:
Required Rate of Return = 5% + 1.5 (12% – 5%)
Required Rate of Return = 15.5%
2. PROBLEM 8-6
EXPECTED RETURNS: Stocks X and Y have the following probability distributions
of expected future returns:
PROBABILITY X Y
0.1 (10%) (35%)
0.2 2 0
0.4 12 20
0.2 20 25
0.1 38 45
a. Calculate the expected rate of return for stock y (rx = 12%)
ANSWER:
STOCK’S EXPECTED
PROBABILITY X RATE OF RETURN =
RETURN
0.1 X (35%) = (3.50%)
0.2 X 0% = 0.00%
0.4 X 20% = 8.00%
0.2 X 25% = 5.00%
0.1 X 45% = 4.50%
14.00%

b. Calculate the standard deviation of expected returns, ơx, for stock X (ơy =
20.35%). Now calculate the coefficient of variation for stock Y. Is it possible that
most investors will regard stock Y as being less risky than stock x? Explain.
ANSWER: CVy = 1.45
If Stock Y is less highly correlated with the market than X, then it
might have a lower beta than Stock X, and hence be less risky in a portfolio
sense.
FORMULA:
RATE OF EXPECTED DEVIATIONS FROM THE
- =
RETURN RETURN (MEAN) MEAN
(10.00%) - 12% = (22.00%)
2.00% - 12% = (10.00%)
12.00% - 12% = 0%
20.00% - 12% = 8.00%
38.00% - 12% = 26.00%

SQUARED
DEVIATION PROBABILITY X
DEVIATION
FROM THE X PROBABILITY = SQUARED
FROM THE
MEAN DEVIATIONS
MEAN
(22.00%) 4.84% X 0.1 = 0.00484
(10.00%) 1% X 0.2 = 0.002
 0% 0% X 0.4 = 0
8.00% 640% X 0.2 = 0.00128
26.00% 6.76% X 0.1 = 0.0076
Variance (ơ)2 = 0.01488
Standard deviation (ơ) = 0.1220 or 12.20%

X = 12.20% versus 20.35% for Y.

CVX = X/ r̂ X = 12.20%/12% = 1.02, while
CVY = 20.35%/14%
CVY = 1.45

3. PROBLEM 8-7
PORTFOLIO REQUIRED RETURN: Jack is the manager of a $10 million mutual
fund and he decides to invest in the three stocks with the following amounts and betas
STOCK INVESTMENT BETA
A $3M 1.60
B 2M 0.90
C 5M (0.70)
If the required market return is 12% and the risk-free rate is 4%, what is the fund’s
required rate of return?
ANSWER: rp = 6.48%
FORMULA:
Portfolio beta = (0.3)(1.6) + (0.2)(0.9) + (0.5)(-0.7)
= 0.48 + 0.18 – 0.35
Portfolio beta = 0.31

rp= rRF + (rM – rRF)(bp)

= 4% + (12% – 4%) (0.31)
rp = 6.48%

4. PROBLEM 8-10
CAPM AND REQUIRED RETURN: Bradford Manufacturing Company has a beta of
1.45, while Farley Industries has a beta of 0.85. The required return on an index fund that
holds the entire stock market is 12.0%. The risk-free rate of interest is 5%. By how much
does Bradford’s required return exceed Farley’s required return?
ANSWER: 4.2%
 An index fund will have a beta of 1.0. If rM is 12.0% (given in the problem) and the risk-
free rate is 5%, you can calculate the market risk premium (RPM) calculated as rM – rRF as
follows:
GIVEN:
Stock Market = 12.0%
Risk-free rate of interest = 5%
FORMULA:
r = rRF + (RPM) b
12.0% = 5% + (RPM) 1.0
7.0% = RPM.

Now, you can use the RPM, the rRF, and the two stocks’ betas to calculate their required
returns.
Bradford Manufacturing Company:
GIVEN:
Beta = 1.45
RPM. = 7.0%
FORMULA:
rB = rRF + (RPM)b
= 5% + (7.0%) 1.45
= 5% + 10.15%
rB = 15.15%
Farley Industries:
GIVEN:
Beta = 0.85
RPM. = 7.0%
FORMULA:
rF = rRF + (RPM)b
= 5% + (7.0%) 0.85
= 5% + 5.95%
rF = 10.95%

The difference in their required returns is:

15.15% – 10.95% = 4.2%

5. PROBLEM 8-13
CAPM, PORTFOLIO RISK, AND RETURN: Consider the following information for
Stocks X, Y, and Z. The returns on the three stocks are positively correlated, but they are
not perfectly correlated. (That is, each of the correlation coefficients is between 0 and 1.)
STOCK EXPECTED STANDARD BETA
RETURN DEVIATION
X 9.00% 15% 0.8
Y 10.75 15 1.2
Z 12.50 15 1.6
 Fund Q has one-third of its funds invested in each of the three stocks. The risk-free rate is
5 5%, and the market is in equilibrium. (That is, required returns equal expected returns.)
a. What is the market risk premium
ANSWER: 4.375% or 4.38%
FORMULA:

Using Stock X (or any stock):

9% = rRF + (rM – rRF) bX
9% = 5.5% + (rM – rRF) 0.8
(rM – rRF) = 4.375% or 4.38%

b. What is the beta of Fund Q?

ANSWER: 1.2
FORMULA:

bQ = 1/3(0.8) + 1/3(1.2) + 1/3(1.6)

bQ = 0.2667 + 0.4000 + 0.5333
bQ = 1.2

c. What is the required return of Fund Q?

ANSWER: 10.75%
FORMULA:

rQ = 5.5% + 4.375%(1.2)
rQ = 10.75%

d. Would you expect the standard deviation of Fund Q to be less than 15%, equal to
15%, or greater than 15%? Explain.
ANSWER: Since the returns on the 3 stocks included in Portfolio
Q are not perfectly positively correlated, one would expect the
standard deviation of the portfolio to be less than 15%.

6. PROBLEM 8-14
PORTFOLIO BETA: Suppose you held a diversified portfolio consisting of a $7,500
investment in each of 20 different common stocks. The portfolio’s beta is 1.12. Now
suppose you decided to sell one of the stocks in your portfolio with a beta of 1.0 for
$7,500 and use the proceeds to buy another stock with a beta of 1.75. What would your
portfolio’s new beta be?
ANSWER: New Portfolio Beta = 1.1575 ≈ 1.16
 FORMULA:
Old portfolio beta = 1.12
7,500investments x 20 different common stocks = 150,000
150,000 – 7,500 = 142,000
Old portfolio beta = $142,500 (b) + $7,500 (1.0)
$150,000 $150,000
1.12 = 0.95b + 0.05
1.07 = 0.95b
1.1263 = Beta
1.12= (0.05) b1 + (0.05) b2 + (0.05) b3 + (0.05) b4 + (0.05) b5 + (0.05) b6 + (0.05)
b7 + (0.05) b8 + (0.05) b9 + (0.05) b10 + (0.05) b11 + (0.05) b12 +
(0.05) b13 + (0.05) b14 + (0.05) b15 + (0.05) b16 + (0.05) b17 +
(0.05) b18 + (0.05) b19 + (0.05) b20
1.12= ( b i ) (0.05)
b i = 1.12/0.05
b i = 22.4
New portfolio beta = (22.4 – 1.0 + 1.75) (0.05)
New Portfolio Beta = 1.1575
New portfolio beta = 0.95(1.1263) + 0.05(1.75)
= 1.07 + 0.09
New Portfolio Beta =1.16

New Portfolio Beta = 1.1575  1.16

7. PROBLEM 8-15
CAMP AND REQUIRED RETURN: AM Inc. has a beta of 1.4 and PM Inc. has a beta
of 0.7. The required market return is 16% and the risk-free rate is 7%. After a financial
crisis the expected rate of inflation built into risk-free rate falls by 2 percentage points
and the required market return falls to 12%. Other conditions do not change. What will be
the respective difference in the required returns for AM Inc. and PM Inc.?
ANSWER: Required Returns of AM Inc. decrease 4.8%
Required Returns of PM Inc. decrease 3.4%
GIVEN:
AM Inc.:
Beta = 1.4
Risk- free rate = 7%
Required Market Return = 16%
PM Inc.:
Beta = 0.7
Risk- free rate = 7%
Required Market Return = 16%
FORMULA:
Required Returns of AM Inc. = 7%+1.4(16%-7%) =19.6%
 Required Returns of PM Inc. = 7%+0.7(16%-7%) =13.3%
After a financial crisis the expected rate of inflation built into risk-free rate falls by 2
percentage points:
New Risk-free = 7% – 2%
New Risk-free = 5%
The required market return falls to 12%:
Required Market Return = 12%

NEW Required Returns of AM Inc. = 5% + 1.4(12% – 5%) =14.8%

NEW Required Returns of PM Inc. = 5% + 0.7(12% – 5%) = 9.9%
Required Returns of AM Inc. = 19.6% - 14.8%
Required Returns of AM Inc. = 4.8%
Required Returns of PM Inc. = 13.3% - 9.9%
Required Returns of PM Inc. = 3.4%

Required Returns of AM Inc. decrease 4.8%

Required Returns of PM Inc. decrease 3.4%

8. PROBLEM 8-17
PORTFOLIO BETA: Suppose you are a manager of a mutual fund and hold a $10
million portfolio with a beta of 1.3. The required market risk premium is 7% and the risk
free is 4%. You expect to invest an additional fund of $5 million, in a number of stocks
and the final required return of the aggregated is expected to be 16%. What should the
average beta of the new stocks added to the portfolio?
ANSWER: X = 2.544
FORMULA:
After additional investments are made, for the entire fund to have an expected return of
16%, the portfolio must have a beta of 1.7143 as shown below:
GIVEN:
Risk premium = 7%
Risk-free = 4%
Final required return of the aggregated is expected to be = 16%
16%= 4% + (7%) b
BETA = 1.7143

Since the fund’s beta is a weighted average of the betas of all the individual investments,
we can calculate the required beta on the additional investment as follows:
GIVEN:
Portfolio = $10 million
Beta of $10 million = 1.3
Expected investment in additional fund = $5 million
FORMULA:
$10 Million + $5 Million = $15 Million
 $10,000,000(1.3) $5,000,000 X
1.7143 = +
$15,000,000 $15,000,000
1.7143 = 0.867 + 0.333X
0.8473 = 0.333X
X = 2.544