FNC3101 FINANCIAL MANAGEMENT

TUTORIAL SOLUTIONS: CHAPTER 8 – RISK AND RETURN

P8-1 Total rate of return (LG 1; Basic)

The total return on an investment is given by:
(𝑃𝑡 − 𝑃𝑡−1 + 𝐶𝑡 )
𝑟𝑡 =
𝑃𝑡−1
where
rt = total return on asset Pt = Price of asset at time t-1
Pt = Price of asset at time t Ct = Cash received between t-1 and t
71,000−63,000+6,100
a. Investment A: Return = = 22.38%
63,000
32,000−35,000+2,800
Investment B: Return = 35,000
= −0.57%

b. Investment A should be selected because it has a higher rate of return for the same
level of risk.

P8-9 Coefficient of variation (LG 2; Basic)

𝜎
The coefficient of variation is given by: 𝐶𝑉 = 𝑟𝑟,
where 𝜎𝑟 is the standard deviation of returns, and 𝑟̅ is expected return
a. The coefficients of variation for projects A, B, C, and D are:
CVA = 6.5  18 = 0.3611
CVB = 11.2  22 = 0.5090
CVC = 5.0  15 = 0.3333
CVD = 3.5  12 = 0.2916
b. Project D has the lowest coefficient of variation, and hence this indicates relatively low
risk.

P8-18 Portfolio analysis (LG 3; Challenge)

a. Expected portfolio return:
Alternative 1: 100% Asset F
16% + 17% + 18% + 19%
rp = = 17.5%
4
Alternative 2: 50% Asset F + 50% Asset G
Asset F Asset G Portfolio Return
Year (wF  rF) (wG  rG) rp
2019 (16%  0.50 = 8.0%) + (17%  0.50 = 8.5%) = 16.5%
2020 (17%  0.50 = 8.5%) + (16%  0.50 = 8.0%) = 16.5%
2021 (18%  0.50 = 9.0%) + (15%  0.50 = 7.5%) = 16.5%
2022 (19%  0.50 = 9.5%) + (14%  0.50 = 7.0%) = 16.5%
16.5% + 16.5% + 16.5% + 16.5%
rp = = 16.5%
4
FNC3101 FINANCIAL MANAGEMENT
TUTORIAL SOLUTIONS: CHAPTER 8 – RISK AND RETURN

Alternative 3: 50% Asset F + 50% Asset H

Asset F Asset H Portfolio Return
Year (wF  rF) (wH  rH) rp
2019 (16%  0.50 = 8.0%) + (14%  0.50 = 7.0%) = 15.0%
2020 (17%  0.50 = 8.5%) + (15%  0.50 = 7.5%) = 16.0%
2021 (18%  0.50 = 9.0%) + (16%  0.50 = 8.0%) = 17.0%
2022 (19%  0.50 = 9.5%) + (17%  0.50 = 8.5%) = 18.0%
15.0% + 16.0% + 17.0% + 18.0%
rp = = 16.5%
4
n
(ri − r )2
b. Standard deviation:  rp = 
i =1 ( n − 1)
,

where ri is asset return in year i (running to year n), and r is average return over n
years:
Alternative 1:
Alternative 1: 100% Asset F

Year Return Average Return Return - Avg. Return (Return - Avg. Return)2
2019 16.0% 17.5% -1.5% 0.000225
2020 17.0% 17.5% -0.5% 0.000025
2021 18.0% 17.5% 0.5% 0.000025
2022 19.0% 17.5% 1.5% 0.000225
Sum of Squared Differences = 0.000500
n-1 3
Sum of Squared Differences / (n-1) = 0.000167
Standard Deviation = σ = 1.291%
FNC3101 FINANCIAL MANAGEMENT
TUTORIAL SOLUTIONS: CHAPTER 8 – RISK AND RETURN

Alternative 2:
Alternative 2: 50% Asset F + 50% Asset G

Year Return Average Return Return - Avg. Return (Return - Avg. Return)2
2019 16.5% 16.5% 0.0% 0.000000
2020 16.5% 16.5% 0.0% 0.000000
2021 16.5% 16.5% 0.0% 0.000000
2022 16.5% 16.5% 0.0% 0.000000
Sum of Squared Differences = 0.000000
n-1 3
Sum of Squared Differences / (n-1) = 0.000000
Standard Deviation = σ = 0.000%

Alternative 3:
Alternative 3: 50% Asset F + 50% Asset H

Year Return Average Return Return - Avg. Return (Return - Avg. Return)2
2019 15.0% 16.5% -1.5% 0.000225
2020 16.0% 16.5% -0.5% 0.000025
2021 17.0% 16.5% 0.5% 0.000025
2022 18.0% 16.5% 1.5% 0.000225
Sum of Squared Differences = 0.000500
n-1 3
Sum of Squared Differences / (n-1) = 0.000167
Standard Deviation = σ = 1.291%

c. Coefficient of variation (CV)  r  r , where σr is standard deviation of the investment

alternative and r is the average return of the investment alternative:
1.291% 0 1.291%
CVF = = 0.0738 CVFG = =0 CVFH = = 0.0782
17.5% 16.5% 16.5%
d. Summary:
r r CV
Alternative 1 (F) 17.5% 1.291% 0.0738
Alternative 2 (FG) 16.5% 0 0.0
Alternative 3 (FH) 16.5% 1.291% 0.0782
Alternative 1 posted the highest return but Alternative 2 the lowest volatility (risk).
When thinking about performance, it is instructive to ask how a hypothetical investor
might view these alternatives. She would first note Alternative 2 is clearly preferable
to Alternative 3 because it offers the same expected return but no volatility in
returns. Now, as between Alternatives 1 and 2, Alternative 1 offers a higher expected
return but also has more volatile returns. Without knowing an investor’s risk
tolerance, it is not possible to say whether Alternative 1 or 2 is “best.”
FNC3101 FINANCIAL MANAGEMENT
TUTORIAL SOLUTIONS: CHAPTER 8 – RISK AND RETURN

P8-32 Manipulating CAPM (LG 6; Intermediate)

a. rj = 5% + [2.2 × (32% − 5%)]
rj = 64.4%
b. 23.75% = RF + [1.25 × (20% − RF)]
RF = 5%
c. 18% = 8% + [1.2 × (rm − 8%)]
rm = 16.33%
d. 15% = 3% + [bj × (15% − 3%)
bj = 1
In a declining market, an investor should choose stocks with a negative beta. When
the market return decreases, the return on C increases.
If you are expecting a potential market rally, an investor should choose an aggressive
stock like Stock B. Its return will be higher than the market return in a booming
market.