CHAPTER

3 Risk and Return

RQ.3.7 Assume the following facts:

— Risk-free return, rf , 7.75 per cent
— Beta, 2
— Expected return of investors, r, 16 per cent
Applying CAPM, compute the expected market return (rm).
Solution RQ.3.7
r = rf + b (rm – rf )
0.16 = 0.0775 + 2(rm – 0.0775)
0.16 = 0.0775 + 2rm – 0.155
0.2375 = 2rm
rm = 0.11875 = 11.87 per cent.
RQ.3.8 The following facts are available:
— rm = 0.14
— rf = 0.0825
— r = 0.18
Compute the beta coefficient (b).
Solution RQ.3.8
r = rf + b (rm – rf)
0.18 = 0.0825 + b (0.14 – 0.0825)
0.18 = 0.0825 + b (0.0575)
0.0975 = b(0.0575)
b = 1.7
RQ.3.16  The following facts are available:
∑ Risk-free rate, 9 per cent
∑ Required rate of return on market portfolio, 18 per cent
∑ Beta coefficient of the shares of ABC Ltd, 1.5
∑ Expected dividend during the next year, `3
∑ Growth rate in dividends/earnings, 8 per cent
Compute the price at which the shares of ABC Ltd should sell.
3.2 Financial Management – OLC

Solution RQ.3.16
Cost of equity (Ke) = Risk-free rate + (Risk Premium)
= 9% + 1.5(18%-9%) = 22.5%
Expected dividend next year (D1) = `3
Growth rate in dividends (g) = 8%
Expected price (P) = D1/(Ke – g)
= 3/(.225 – .08)
= `20.7
RQ.3.17 The probability distribution of expected future returns is as follows:
Probability Return on shares (percentage)
X Y
0.1 (16) (18)
0.2 2 12
0.4 8 18
0.2 12 32
0.1 20 40

Compute the (a) standard deviation of expected returns of each share, (b) coefficient of
variation. Which share is more risky? Why?
Solution RQ.3.17
(a) Computation of standard deviation of shares, X and Y
ri(%) Pi riPi  (%) (ri – r)(%) (ri – r)2 (ri – r) 2Pi   (%)
(1) (2) (3) (4) (5) (6)
Share X:
(16) 0.1 (1.6) (22.4) 501.8 50.2
2 0.2 0.4 (4.4) 19.4 3.9
8 0.4 3.2 1.6 2.6 1.0
12 0.2 2.4 5.6 31.4 6.3
20 0.1 2 13.6 185.0 18.5
s 2 = 6.4 s 2 = 79.9

Since s 2 = 80, s = 80 = 8.94 per cent

Share Y:
(18) 0.1 (1.8) (36.2) 1,310.4 131.04
12 0.2 2.4 (6.2) 38.4 7.68
18 0.4 7.2 (0.2) 0.04 0.02
32 0.2 6.4 13.8 190.4 38.08
40 0.1 4 21.8 475.2 47.52
s = 18.2 s 2 = 224.34

Since s 2 = 224.34, s = 224.34 = 14.98 per cent

(b) Coefficient of variation:

Share X = 8.94/6.4 = 1.4
Share Y = 14.98/18.2 = 0.82
Share X is more risky since it has larger coefficient of variation (a measure of relative risk).
Risk and Return 3.3
RQ.3.18 The rate on T-bill (risk-free return, rf ) is currently 7.75 per cent, while the expected market
return (rm) is 14.25 per cent. Compute the required rate of return of each security listed
below:

Security Beta
X1 1.5
X2 1.2
X3 1.00
X4 0.90

Solution RQ.3.18
Security Risk-free return (rf ) + b[rm – rf ] = r(per cent)
(per cent) (per cent)
(1) (2) (3) (4)
X1 7.75 1.5(14.25 – 7.75 = 6.5) 17.50
X2 7.75 1.2(14.25 – 7.75 = 6.5) 15.55
X3 7.75 1.0(14.25 – 7.75 = 6.5) 14.25
X4 7.75 0.9(14.25 – 7.75 = 6.5) 13.60

RQ.3.21  The total market value of the equity share of ORE Company is `60,00,000 and the total value
of the debt is `40,00,000. The treasurer estimates that the beta of the stock is currently 1.5
and that the expected risk premium on the market is 10 per cent. The treasury bill rate is
8 per cent.
Required: (i) What is the beta of the company’s existing portfolio of assets? (ii) Estimate the
company’s cost of capital and the discount rate for an expansion of the company’s present
business.
Solution RQ.3.21
(i) bequity = bassets(1+Debt/Equity)
1.5 = bassets(1+2/3)
bassets = 1.5 ¥ 3/5
= 0.9
(ii) Cost of equity = Risk-free rate + b(Risk Premium)
= 8% + 1.5(10%) = 23%
Cost of debt = 8%
Weighted average cost of capital
= Cost of equity (equity/ debt+equity) + cost of debt(debt/debt+equity)
= 23%(0.6) + 8% (0.4)
= 13.8% + 3.2% = 17%
RQ.3.22 The expected return (r ) and standard deviation (s) of shares of X Ltd and Y Ltd are:

r s
X Ltd 0.14 0.20
Y Ltd 0.09 0.30

Required: If the expected correlation between the two shares (pxy) is (a) 0.1, (b) -1, compute
the return and risk for each of the following portfolios: (i) X, 100 per cent, (ii) Y, 100 per
cent, (iii) X, 50 per cent and Y, 50 per cent.
3.4 Financial Management – OLC

Solution RQ.3.22
(a) pxy = 0.1
(i) X, 100 per cent: s/r = 0.20/0.14 = 1.43
(ii) Y, 100 per cent: s/r = 0.30/0.09 = 3.33
(iii) X, 50 per cent; Y, 50 per cent:
rp = w x rx ¥ w y r y = (0.5) (0.14) + (0.5) (0.09) =11.5 per cent

sp = w x2 s x2 + w y2 s 2y + 2 w x w y p xy s x s y

= ( 0.5 )2 ( 0.2 )2 + ( 0.5 )2 ( 0.3 )2 + 2 ( 0.5 )( 0.5 ) p xy ( 0.2 )( 0.3 )

= 0.01 + 0.0225 + 0.03 p xy = 0.035 + 0.03 p xy

= 0.0325 + 0.03 ( 0.1 ) = 0.0355 = 0.1884 = 18.84 per cent

(b) Pxy = –1
(i) and (ii) same as in (a) (i) and (ii).
(iii) rp = 11.5 per cent
sp = 0.0325 + 0.03 ( -1 ) = 0.0025 = 0.05 = 5 per cent

RQ.3.23 The aggregate average rf and rm for a 3-year period are 10 per cent and 18 per cent respec-
tively. The results for four portfolios during the same period are summarised as follows:

Portfolio Average return (per cent) Beta

X1 18 0.90
X2 18 1.12
X3 24 1.50
X4 16 0.95

Using the CAPM, compute the expected return for each portfolio and compare the actual
and expected returns. Which portfolio has performed the best?
Solution RQ.3.23
Expected returns
Portfolio Expected return Actual return Difference between actual
(per cent) (per cent) and expected returns
(per cent)
X1 0.10 + 0.90 (0.18 – 0.10) = 17.2 18 0.8
X2 0.10 + 1.12 (0.18 – 0.10) = 19.0 18 (1)
X3 0.10 + 1.50 (0.18 – 0.10) = 22.0 24 2
X4 0.10 + 0.95 (0.18 – 0.10) = 17.6 16 (1.6)

Portfolios X1 and X3 have been better than expected. The performance of X1 has exceeded the expected
return by 4.65 per cent (0.8 ∏ 17.2), while the performance of X3 has exceeded the expected return
by 9.1 per cent (2 ∏ 22). Thus, portfolio X3 has shown the best performance.