Solutions Manual

to accompany

Introducing
Corporate Finance 2e
Diana Beal, Michelle Goyen
Abul Shamsuddin

Prepared by

Michelle Goyen

© John Wiley & Sons Australia, Ltd 2008

Chapter 5: Understanding Risk and Return

End of Chapter Questions

5.1 What is a ‘return’? Demonstrate your understanding by explaining how

to calculate the return on a bond and the return on a share.

A return is the gain or loss achieved by making an investment. The return on a bond is
calculated as the difference between the price at the start of the period and price at the
end of the period plus any coupons received during the period all divided by the
purchase price. Therefore, the return on a bond includes the capital gain or loss plus
the income (coupon payments) scaled by the price at the start of the period. The return
on a share is calculated the same way, but as dividends are paid on shares, these
replace the coupons in the bond example.

5.2 What are ex post and ex ante returns and why do we differentiate
between them?

A return is the gain or loss achieved by making an investment. Ex post returns are
those that can be observed because they have already happened. Ex post returns have
been generated in the past. Ex ante returns are those that are expected to occur at some
future time. They cannot be observed because they have not happened yet. It is this
expected future return that is relevant to investment decisions. Past returns may
provide some indication of future returns, but the future is always uncertain so past
returns are not always suitable indicators of future returns for risky assets.

5.3 Explain the nature of capital gains and losses and explain how they affect
the calculation of returns.

A capital gain results from a higher share price at the end of the period (Pt) than it was
at the start of the period (Pt–1). Thus a capital gain represents the increase in wealth
that results from selling at a higher price than the share was purchased for. When the
ending share price is lower than the price at the start of the period, the shareholder has
made a capital loss. Dividends are not the only source of return on a share. Capital
gains increase the return when added to any dividend payments. Capital losses
decrease the return. When a capital loss is larger than the dividend paid on the share,
the return for the period will be negative (a loss or decrease in wealth).

5.4 What is a ‘holding period return’? What is the conventional time period
used when discussing returns?

A holding period return is the return an investor would earn if the share was
purchased at the start of the period and sold at the end of the period. The holding
period return could cover a period from an hour to 100 years. We cannot compare
holding period returns unless the period is the same length. It doesn’t make sense to

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 Chapter 5: Understanding Risk and Return

say one investment returned 10% in 2 years, so it is better than an investment that
returned 5% in six months. By convention, returns like interest rates, are stated on an
annual basis.

5.5 Look at figure 5.1. What does the graph tell you about risk and ex post
returns?

Figure 5.1 shows the annual returns on shares (represented by the All Ordinaries
Accumulation Index) and the return on long-term government debt securities.
Government issued debt represents the risk-free rate because governments are usually
considered to have a very low default risk. Debtholders have a contractual right to
receive the interest payments on their securities, so there is relatively little variation in
return. The return on bonds shown in the graph is represented by a relatively even
line. It has a slight downward slope because interest rates tended to fall over the
1996–2003 period.

Examining the annual return on shares over the period we find positive returns of up
to 80% and negative returns as low as –30%. The share line is not nearly as stable (i.e.
shows more volatility) as the return on bond line. The large variations in share returns
indicate that shares are a riskier investment than the relatively stable bonds. From
Figure 5.1, we can conclude that the riskier asset (shares) had much higher and much
lower returns than the lower risk bonds. It appears that, ex post, the lower risk asset
also had lower returns.

5.6 Your friend has calculated an expected return of 4.7% for CSL Ltd. He is
confused, as 4.7% was not identified as a possible outcome. Explain to
your friend how this result can occur.

Tell your friend that the expected return does not have to equal any of the possible
returns identified ex ante. This is due to the role the weightings play in the calculation
of expected return. The most likely outcome is heavily weighted and contributes the
most to expected return while the least likely outcome (the chance of a loss) decreases
the expected return by a relatively small amount. Adding the weighted returns
together frequently results in a total expected return that is different to any of the
identified possible outcomes.

5.7 What is the maximum possible percentage loss you can make on the
purchase of an ordinary share? What is the maximum possible
percentage gain you can make on the purchase of an ordinary share?
Explain your answers.

The maximum possible percentage loss you can make by investing in a share is 100%.
If you pay $10.00 for a share and the company liquidates, you may loose your entire
investment. The maximum possible gain on an ordinary share is infinite — there are
no constraints on how high a share price can go.

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Introducing Corporate Finance 2e Solutions Manual

5.8 How is the definition of risk in finance different from the way people
ordinarily think of risk? Why is the distinction important?

Risk, in finance, is defined as the chance that the actual outcome from an investment
will be different from the expected outcome. The everyday usage of the word ‘risky’
tends to have the negative connotation of being dangerous and again is a pessimistic
view. When we describe something as ‘risky’ in finance, we are saying that the
returns are variable or that the actual outcome can be different from the expected
outcome. The terms ‘risk’ and ‘risky’ are value neutral when used in finance. In
everyday usage, these terms tend to be used to convey the idea that something bad
will happen.
In finance, risk is synonymous to uncertainty, not to loss. This distinction is important
because investing in a ‘risky’ asset means you may make a loss, but it also implies
that you might make a gain large enough to encourage you to take the risk.

5.9 What is a ‘standard deviation’? What does it tell us when a distribution is

normal? Use figure 5.4 to help your explanation.

The standard deviation is the square root of the variance. The variance considers the
absolute deviations from the mean (or expected) return, but gives an answer in square
percent. The standard deviation for a normal distribution is informative because it
allows us to calculate the range of outcomes that will include 68% of the possible
outcomes. We add one standard deviation to the mean and subtract one from the mean
to calculate this range. We can expect that an outcome will occur within this range
68% of the time. Similarly, 95% of the distribution will fall in the range of the mean
plus two standard deviations and the mean minus two standard deviations. Three
standard deviations above and below the mean include 99.7% of the distribution.

5.10 You have been offered the choice of two games. The first game gives you
the chance of doubling your money or losing it all. The second game gives
you the chance of winning 50% of your bet or losing 50% of it. Which
game would be preferred by:
(a) a risk-averse person?
(b) a risk-neutral person?
(c) a risk-seeking person?

Both are fair games and have an expected value of zero. The following calculations
are based on a bet of $100, but the dollar amount is irrelevant.
Using equation 4.2

Game 1 = 0.5(100) + 0.5(–100)

= 50 – 50 = 0
Game 2 = 0.5(50) + 0.5(–50)
= 25 – 25 = 0
Game 1 has the wider dispersion of possible outcomes, so is the riskier of the two.
 A risk-averse person would not want to play either of these games.
 A risk-neutral person would not care which game she played.
 A risk-seeking person would choose Game 1 because it has the higher risk.

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 Chapter 5: Understanding Risk and Return

While both games have expected values of zero (i.e. identical expected return), they
have different distributions of possible outcomes. The narrow distribution of game 2
would be more attractive to a risk-averse person (if they were forced to chose one of
the games) and the wider distribution for game 1 would be more attractive to a risk
seeker.

5.11 Explain what is meant by the term ‘risk aversion’ and provide a rationale
for risk-averse investors participating in the market.

A risk-averse person will not participate in a fair game. This type of person does not
like to take risks and feels uncomfortable when they do take risks. Traditional finance
theory is based on the assumption that market participants are risk-averse. This
assumption implies that market participants will not choose to invest when the
probabilities for losing or gaining a dollar amount generate an expected value of zero
(a fair game). However, risk-averse investors will invest when they think the expected
value of the investment is positive (i.e. the investment not a fair game, but one biased
in the investor’s favour). This means risk averters will hold risky assets when the
expected return is sufficiently large enough to compensate them for taking on risk.

5.12 Define ‘expected return’ and ‘required return’. What is the relationship
between these two concepts?

The expected return is the probability-weighted average of possible outcomes

associated with the investment. Expected return is essentially a forecast of the return
that will be generated by purchasing an asset. The required rate of return on an
investment is the minimum level of return that is acceptable to an investor given the
level of risk associated with that investment. Thus, required return is the amount that
will induce an investor to hold the risky asset, given that particular investor’s level of
risk aversion. We can use expected returns and required returns to establish if an
investor should hold a particular asset or not. Consider an investor with a required
return of 10% for some given level of risk. She has calculated the expected returns for
two assets with that same given level of risk. The expected return for the first asset is
12% and 8% is expected for the second asset. The investor will purchase the first asset
(expected return 12% > 10% required return) and will not purchase the second
(expected return 8% < 10% required return).

5.13 Do all risk-averse investors make the same investment decisions? Why?

Not all risk-averse investors choose the same investments. There are different levels
of risk aversion within the category ‘risk-averse’. For example, people who are
extremely risk-averse might only invest in debt securities and not invest in the share
market at all. People a bit further along the scale might choose to invest in well know
companies with a long history and a reputation for paying dividends. Others may
invest in many types of companies if they consider that the expected return is high
enough to justify taking on the additional risk.

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Introducing Corporate Finance 2e Solutions Manual

5.14 What is ‘correlation’? Demonstrate your understanding by examining the

situation of perfect positive correlation of 2 assets and by explaining what
will happen with perfect negative correlation.

Correlation is a measure of the way two variables move relative to each other. If two
assets are perfectly positively correlated, their prices or returns (depending on which
of these are correlated) will move by the same amount and in the same direction. For
example, if the prices of two assets are perfectly positively correlated, a 2% increase
in the price of one asset will be associated with a 2% increase in the price of the
second asset. If two assets have perfect negative correlation, the price or return will
move by the same amount, but in opposite directions. For example, a price increase of
2% for one of the assets will be associated with a price decrease of 2% for the other
asset.

5.15 What is diversification and how does it work? Which would be the riskier
of the following portfolios?
(a) five residential properties that are leased out
(b) two residential properties for leasing and shares in five listed
companies
(c) bonds issued by the Australian government

A portfolio is a collection of different assets and diversification refers to the spread of

different assets held in a portfolio. A portfolio with a large number of different types
of assets is well-diversified, while a portfolio that contains shares in two companies
that operate in the same industry is not well-diversified. Diversification reduces risk
because the returns on many different individual assets are not likely to move in the
same direction and by the same amount (i.e. they are not perfectly positively
correlated).

The more diversified a portfolio is, the less risk it will have. Ignoring the fact that
shares and property are inherently more risky than bonds and concentrating on the
level of diversification, we would chose (b) would have the least risk portfolio.
Portfolio (b) contains more than one type of asset (property and shares) and we do not
expect these asset returns to be highly correlated. Portfolios (a) and (c) are riskier than
(b) because they are less diversified. Portfolio (a) may be more diversified than (c) if
the properties are located in different geographic areas. Portfolio (c) must have the
lowest level of diversification because only one type of asset is held. If interest rates
fall dramatically, an investor holding portfolio (c) will face significant losses.

5.16 Can you achieve risk reduction by combining positively correlated assets?
Explain your answer.

Combining two assets that are not perfectly positively correlated will result in a
decrease in risk. The greatest risk reduction occurs with negatively correlated assets,
but anything less that perfect positive correlation will also reduce risk. If two assets
are perfectly positively correlated, they must be affected by exactly the same levels
and types of unsystematic risks. Anything less than perfect positive correlation will

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 Chapter 5: Understanding Risk and Return

allow some unsystematic risk for one asset to be offset against that of the second
asset.

5.17 What is ‘systematic risk’? What is ‘unsystematic risk’? Give some

examples of sources of both types of risk to demonstrate your
understanding.

Systematic risk is the risk that is common to all businesses. Some sources of
systematic risk include the rate of job growth in the economy (more people working
means more money being spent), changes in the interest rate (the more people have to
pay to borrow money the less they will consume) and war (if your property is at risk
of being destroyed, you are unlikely to purchase more property).

Unsystematic risk comes from the way a particular business conducts its activities.
Sources of unsystematic risk include technological change (how many blacksmiths do
you know of compared to how many your great grandparents would have known of),
changes in society (consider the fall in the percentage of the population who smoke
cigarettes now compared to the percentage in the 1940s) and fashion (if you were a
fabric manufacturer, the demand for your products would vary with the fullness of
women’s skirts).

5.18 Which type of risk does diversification reduce? Explain why only one type
of risk can be reduced by diversification.

Diversification reduces unsystematic risk. Systematic risk cannot be reduced because

it is common to all businesses. Unsystematic risk can be reduced. If you hold a
diversified portfolio, your wealth is distributed across a number of businesses. The
failure of one business does not make you bankrupt. Further, the reasons for the
failure of one of the businesses in your portfolio may provide new opportunities for
the other businesses in your portfolio to increase returns. Can you think of any
situations where this might occur?

5.19 Are higher expected returns associated with increased total risk or
increased systematic risk? Why?

Higher expected returns are only associated with higher levels of systematic risk.
Total risk includes both systematic and unsystematic components. The unsystematic
risk can be diversified away — if you choose not to diversify, you bear the costs.

5.20 The CAPM uses the expected return on the market portfolio to calculate
the expected return on a risky asset. What is the market portfolio?
Describe one of the indices that is used to approximate the market
portfolio.

Theoretically, the market portfolio should be consistent with holding all types of risky
assets from around the world. This would include shares in companies from all

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Introducing Corporate Finance 2e Solutions Manual

nations, corporate debt issued by many companies in many countries, real estate in
different locations around the world, precious metals and any other valuable and risky
asset that you can think of. It is not feasible to identify, let alone value and track
changes in value on the true market portfolio, so it is usually approximated by a
domestic share price index which represents a diversified portfolio of shares. The All
Ordinaries Accumulation index is constructed by taking the share prices of a group of
companies listed on the ASX and weighting them according to their relative size in
the market. It is assumed that dividends paid by the companies are reinvested, so they
increase the index.

5.21 (a) Explain how the following asset’s returns would respond to a 1%
increase in the market return
i) β=1
β = 1, the asset’s return increases by the same 1% as the market

ii) β=2
β = 2, the asset’s return increases by 2%

iii) β = –1
β = –1, the asset’s return decrease by 1%

(b) Explain how much systematic risk the following assets have
compared to the market
i) β=1
β = 1, same level of systematic risk as the market

ii) β=2
β = 2, twice as much systematic risk as the market

iii) β = -1
β = –1, same level as the market, but returns move in the opposite direction to the
market

5.22 You identify several shares with forecast returns that lie above the
security market line. Should you buy or sell these shares? Why?

You should buy these shares. Shares that lie above the security market line are
underpriced – you would be willing to pay more for these shares given their levels of
systematic risk and the expected returns on other shares with the same level of
systematic risk.

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 Chapter 5: Understanding Risk and Return

Financial Problems

5.1 You paid $5.60 for a share and received dividends of $0.23 during the
year you owned the share. You sold share for $5.95 at the end of the year.
What was your holding period return?

Pt  Pt 1  D
R  100
Pt 1

5.2 Calculate the annual return on the following shares.

Using equation 5.1

= 11.4%

= 11.43%

= 0%

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Introducing Corporate Finance 2e Solutions Manual

5.3 You have forecast the following possible returns and associate
probabilities for shares of Green Ltd:

Calculate the expected return.

5.4 Calculate the variance and standard deviation of returns for the Green
Ltd share in problem 5.3.

5.5 Calculate the return on the following shares:

Using equation 5.2

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 Chapter 5: Understanding Risk and Return

= 0.015 + 0.025 + 0.05 + 0.008 – 0.0375

= 0.0605 or 6.05%

= 0.0125 + 0.02 + 0.06 + 0.004 – 0.0225

= 0.074 or 7.4%

= 0.01 + 0.016 + 0.04 + 0 – 0.015

= 0.051 or 5.1%

© John Wiley and Sons Australia, Ltd 2008 5.10

5.6 Calculate the standard deviations of KLM Ltd, NOP Ltd and QRS Ltd from the information given in
problem 5.5. Which asset has the highest level of risk?

Using equation 4.4

= 0.147597 or 14.76%

= 0.110923 or 11.09%

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 Chapter 5: Understanding Risk and Return

= 0.0816027 or 8.16%

Shares in KLM Ltd have the highest level of risk because they have the highest standard deviation.

© John Wiley and Sons Australia, Ltd 2008 5.12

5.7 The returns on Blue Ltd shares for the last 5 years are as follows:

Calculate the variance and standard deviation for Blue Ltd.

or 6.48%

5.8 Calculate the standard deviation of returns for the following three assets.

Which has the highest level of risk?

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 Chapter 5: Understanding Risk and Return

Using equations and

= 0.04 / 4
= 0.01 or 1%

= 0.04561 or 4.56%

= 0.1 / 4
= 0.025 or 2.5%

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Introducing Corporate Finance 2e Solutions Manual

= 0.071414 or 7.14%

= 0.17 / 4
= 0.0425 or 4.25%

= 0.043493 or 4.35%
The shares in DEF Ltd have the highest risk as represented by a standard deviation of
7.14%.

5.9 Use the standard deviations you calculated in problem 5.8 and assume the
returns are drawn from a normal distribution. In what range of returns will
68% of all observations fall?

68% of all observations fall in the range of the mean plus or minus one standard
deviation. Therefore:

σ -σ +σ Range
ABC Ltd 0.0456 0.01 –0.0356 0.0556 –3.56 to 5.56%
DEF Ltd 0.0714 0.025 –0.0464 0.0964 –4.64 to 9.64%
HIJ Ltd 0.0435 0.0425 –0.001 0.04925 –0.01 to 8.6%

5.10 The standard deviation and expected returns for two portfolios are as
follows.

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 Chapter 5: Understanding Risk and Return

Which portfolio would you prefer to hold? Why? Why can two portfolios
with the same standard deviation have different expected returns?

Portfolio 2 would be preferred because it has a higher expected return (10 > 6) for the
same amount of risk (the standard deviations of the portfolio are equal).

To take on more risk, investors need to be compensated by higher expected returns. This
leads to the expected relationship of increasing return with increasing risk. This
relationship does not imply that all assets of the same risk will have the same expected
return. It does mean that, when comparing investment alternatives with the same level of
risk, investors will prefer the portfolio with the highest expected return. They will not
hold Portfolio 1. We would expect that the prices of the assets in Portfolio 1 would fall
(because investors chose not to hold them) until the expected return on Portfolio 1
increased to match the expected return on Portfolio 2.

5.11 Look at the beta for each of the following companies. Using just this
information, make some predictions about the return for each company.

Company Beta Market β Relationship

Red Ltd 1.7 1 more volatile, positive
Blue Ltd 1 1 equal to market
Green Ltd 0 1 none
Purple Ltd –0.1 1 slightly more volatile, inverse

Predictions
 Red Ltd would have the highest expected return if the market had a positive
expected return. Red’s expected return would be higher than that of the market.
 Blue Ltd’s expected return would be the same as that for the market.
 Green Ltd’s expected return is unrelated to what happens on the market, so we
cannot predict the size or direction of any movement in relation to the expected
return on the market.

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Introducing Corporate Finance 2e Solutions Manual

 Purple Ltd’s expected return would be lower than that of the market. If the market
was expected to increase, there would be a decrease in the expected return for
Purple Ltd.

5.12 You have forecast the return on the All Ordinaries Accumulation Index to be
6% in the coming year. The rate on 10-year Treasury bonds is 4.5%.
Calculate the expected return for the companies identified in problem 5.11.

Using equation E(R) = Rf + β (E(Rm) – Rf)

E(R)RED = 0.045 + 1.7 (0.06 – 0.045)
= 0.045 + 1.7 (0.015)
= 0.045 + 0.0255
= 0.0705 or 7.05%
E(R)BLUE = 0.045 + 1 (0.06 – 0.045)
= 0.06 or 6%
E(R)GREEN = 0.045 + 0 (0.06 – 0.045)
= 0.045 or 4.5%
E(R)PURPLE = 0.045 + -0.1 (0.06 – 0.045)
= 0.0435 or 4.35%

5.13 What is the expected return for a share with a beta of 1.5 when the return on
the market is expected to be 15% and the risk-free rate is 3%?

5.14 Microsplat is a highly successful manufacturer and vendor of computer

software. The company has been growing rapidly and has never paid a
dividend. Share prices for the last 10 years are as follows:

(a) Calculate the annual return for each year.

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Pt-1 Pt R%
1997 1.20 4.60 283.33
1998 4.60 5.90 28.26
1999 5.90 10.36 75.59
2000 10.36 23.79 129.63
2001 23.79 27.39 15.13
2002 27.39 30.02 9.60
2003 30.02 35.78 19.19
2004 35.78 40.69 13.72
2005 40.69 42.50 4.45

(b) Calculate the variance and standard deviation of the annual returns

or 91.69%

5.15 Two assets have the same level of risk. You have collected the following
information about the last year of operation for each of the assets:

(a) Calculate the return on each of the assets.

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Introducing Corporate Finance 2e Solutions Manual

(b) Assume you are a risk averse investor. Which of these assets would you
prefer to have owned?

You should prefer to own Asset 1 because it generates the highest return for the same
level of risk as Asset 2.

5.16 You have calculated the following annual historical returns data for three
companies:

(a) Calculate the standard deviation for each of the shares.

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 Chapter 5: Understanding Risk and Return

or 4.7%

or 3.1%

or 6.2%

(b) Which share has the highest level of risk? Which has the lowest?

Company 3 has the highest risk (σ = 6.2%) while Company 2 has the lowest (σ = 3.1%)

5.17 You have collected the following monthly closing prices for three companies
(CAT, CBA and CSL):

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Introducing Corporate Finance 2e Solutions Manual

(a) Assuming the companies paid no dividends over the period, calculate
the monthly return for each of the shares.

CAT Pt-1 Pt R%
August 5.10 4.80 –5.88
September 4.80 4.79 –0.21
October 4.79 3.62 –24.43
November 3.62 3.62 0
December 3.62 3.65 0.83
January 3.65 3.55 –2.74

CBA Pt-1 Pt R%
August 32.11 31.10 –3.15
September 31.10 31.42 1.03
October 31.42 30.20 –3.88
November 30.20 28.86 –4.44
December 28.86 27.18 –5.82
January 27.18 27.34 0.059

CSL Pt-1 Pt R%
August 31.14 28.25 –9.28
September 28.25 22.37 –20.81
October 22.37 21.61 –3.4
November 21.61 17.30 –19.94
December 17.30 23.13 33.7
January 23.13 21.47 –7.18

(b) Which of the shares had the highest standard deviation and what does
this tell you about the associated risk?

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 Chapter 5: Understanding Risk and Return

unrounded solution

or 9.64%
unrounded solution

or 2.8%
unrounded solution

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Introducing Corporate Finance 2e Solutions Manual

or 19.98%
unrounded solution

CSL Ltd had the highest standard deviation (19.98%). This tells us that CSL had the
highest level of risk.

5.18 You have forecast the returns and associated probabilities for the following
three companies:

(a) Calculate the expected return on each share.

(b) Calculate the variance for each share.

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 Chapter 5: Understanding Risk and Return

(c) Calculate the standard deviation for each share

or 1.04%

or 3.32%

or 6.57%

5.19 You have forecast an equity risk premium of 7%. The risk free rate is 5%.
Calculate the expected return on the following three shares:

(a) What is the expected return for each company?

or 13.82%

or 10.6%

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Introducing Corporate Finance 2e Solutions Manual

or 0.52%

(b) Which company has the highest level of risk? How can you tell?

Sims Ltd has the highest level of risk because it has the largest beta.

(d) Which company would you like to be holding when the market takes a
downturn? Why?

Knight-Day Ltd has a negative beta. This means that when the market falls, the returns on
Knight-Day Ltd are expected to increase. Therefore, this would be the preferred share in
a market downturn.

5.20 Complete the risk preference survey in the Finance World box on page 000.
Use this knowledge of your risk preferences to identify your preferred
investment from those identified in problem 5.19.

The solution to this problem depends on your risk preferences:

Score 15–35
Knight-Day Ltd has the lowest absolute level of risk, so would be suitable for the most
risk averse investors. However, the negative beta tells us that the expected return will be a
loss when the market is expected to make a gain. If you are also loss averse (see the
second behavioural perspectives box) and you know that the share market gives negative
returns one year in seven on average, you will not choose this investment even though it
has the lowest level of risk.
Score 36–52
Simpsons Ltd offers closest to the market level of risk (i.e. beta = 1). This is likely to be
suitable for people in this score range. However, Sims Ltd is not that much riskier than
the market and some people would have chosen this alternative
Score 53–68
Sims Ltd would be the preferred investment for these people because it offers a higher
risk — higher expected return option.

5.21 You expect a return on the market of 15% and the risk-free rate to be 3%.
The beta for Zed Ltd is 0.89 and it is priced to return 14%. Is Zed Ltd fairly
priced? Would you buy or sell Zed Ltd?

or 13.68%

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The expected return for Zed Ltd based on its level of systematic risk is 13.68%. The
company is currently priced to return 14%. As this return is higher than would be
expected for the level of systematic risk, Zed Ltd is underpriced. You would buy the
shares of Zed and earn a return higher than would be expected for the level of systematic
risk.

© John Wiley and Sons Australia, Ltd 2008 5.26