CFIN 4 4th Edition Besley Solutions

Manual
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Chapter 8 CFIN4

Chapter 8 Solutions

8-1 a. r̂ = (0.2)(19%) + (0.7)(9%) + (0.1)(4%) = 10.5%

b.  = (0.2)(19 - 10.5)2 + (0.7)(9 - 10.5)2 + (0.1)(4 - 10.5)2 = 20.25 = 4.5%

4.5%
c. CV = = 0.429
10.5%

8-2 a. r̂ = (0.45)(32%) + (0.35)(-4%) + (0.2)(-20%) = 9.0%

b.  = (0.45)(32 - 9)2 + (0.35)( −4 − 9)2 + (0.2)( −20 − 9)2 = 465.4 = 21.573%

21.573%
c. CV = = 2.397
9%

8-3 a. r̂A = (0.3)(30%) + (0.2)(10%) + (0.5)(-2%) = 10%

r̂B = (0.3)(5%) + (0.2)(15%) + (0.5)(25%) = 17%

b.  A = (0.3)(30 - 10)2 + (0.2)(10 − 10)2 + (0.5)( −2 − 10)2 = 192 = 13.856%

B = (0.3)(5 - 17)2 + (0.2)(15 − 17)2 + (0.5)(25 − 17 )2 = 76 = 8.718%

13.865%
c. CV A = = 1.387
10%

8.718%
CV B = = 0.513
17%

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Chapter 8 CFIN4

8-4 To answer the question, the coefficient of variation for each investment must be computed.

Investment r̂  CV
Stock M 6.0% 4.0% 0.667 = 4%/6%
Stock N 18.0 12.0 0.667 = 12%/18%
Stock O 12.0 7.0 0.583 = 7%/12%

According to the CV measure, Stock O has the best risk/return relationship; its risk per unit of return is
the lowest at 0.583.

8-5 To answer the question, the coefficient of variation for each investment must be computed.

Investment r̂  CV
F 16.0% 7.0% 0.438 = 7%/16%
G 27.0 13.0 0.481 = 13%/27%

According to the CV measure, Investment F has the better risk/return relationship; its risk per unit of
return is the lower at 0.438.

8-6 $9,000 invested in one stock with an 18 percent expected return

$21,000 invested in a second stock with an 8 percent expected return

 $9,000   $21,000 
r̂P =   18% +  $9,000 + $21,000  8%
 $9,000 + $21,000   

= 0.3(18%) + 0.7(8%) = 11.0%

8-7 Portfolio return:

Amount Weight Return Portfolio Return

Investment (1) (2) (3) (4) = (2) x (3)

DEF $ 30,000 0.30 = $30,000/$100,000 4.0% 1.2%

KJL 25,000 0.25 = $25,000/$100,000 24.0 6.0
TUV 45,000 0.45 = $45,000/$100,000 14.0 6.3
$100,000 1.00 13.5%

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Chapter 8 CFIN4

8-8 Portfolio beta:

Investment Weight Beta Portfolio beta

(1) (2) (3) (4) = (2) x (3)

$ 350,000 0.35 = $350,000/$1,000,000 1.0 0.35

250,000 0.25 = $250,000/$1,000,000 0.2 0.05
400,000 0.40 = $400,000/$1,000,000 2.5 1.00
$1,000,000 1.00 1.40

rp = rRF + (rM – rRF)(βp) = 3% + (9% – 3%)1.4 = 11.4%

Alternative solution: First compute the return for each stock using the CAPM equation
[rRF + (rM – rRF)βj], and then compute the weighted average of these returns.

rRF = 3% and rM – rRF = 9%.

rj = rRF + (rM – rRF)βj

Investment Beta = 3% + (9% – 3%)βj Weight rP
(1) (2) (3) (4) (5) = (3) x (4)

$ 350,000 1.0 9.0% 0.35 3.15%

250,000 0.2 4.2 0.25 1.05
400,000 2.5 18.0 0.40 7.20
Total $1,000,000 1.00 11.40%

rp = 9.0%(0.35) + 4.2%(0.25) + 18.0%(0.40) = 11.4%.

8-9 a. r̂ABC = (0.1)(22%) + (0.6)(12%) + (0.3)(2%) = 10.0%

r̂RST = (0.1)(-2%) + (0.6)(12%) + (0.3)(30%) = 16.0%

b.  ABC = (0.1)(22 - 10)2 + (0.6)(12 − 10)2 + (0.3)(2 − 10)2 = 36 = 6.000%

RST = (0.1)( −2 − 16)2 + (0.6)(12 − 16)2 + (0.3)(30 − 16)2 = 100.8 = 10.040%

c. Compute the expected return of the portfolio

Probability rABC rRST Portfolio Return: 60% ABC; 40% RST

0.1 22.0% -2.0% 12.4% = 0.6(22%) + 0.4(–2%)
0.6 12.0 12.0 12.0 = 0.6(12%) + 0.4(12%)
0.3 2.0 30.0 13.2 = 0.6( 2%) + 0.4(30%)
Expected return 10.0% 16.0% 12.4% = 0.6(10%) + 0.4(16%)

rP = 0.1(12.4%) + 0.6(12.0%) + 0.3(13.2%) = 12.4%

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Chapter 8 CFIN4

P = (0.1)(12.4 - 12.4)2 + (0.6)(12 − 12.4)2 + (0.3)(13.2 − 12.4)2 = 0.288 = 0.537%

d. The portfolio standard deviation is much lower than the standard deviation for either of the
investments, because the investments’ returns are negatively correlated. Notice that when
Investment ABC’s return is highest, Investment RST’s return is lowest, and vice versa. In fact, the
two investments’ returns are strongly negatively correlated, which resulted in a substantial
reduction is risk when the two investments were combined to form a portfolio.

8-10 Total investment = $60,000

ws = 0.40
wX = 0.60
βs = 1.5
βP = 2.1

βP = 2.1 = 0.4(1.5) + 0.6(βX)

0.6(βX) = 2.1 – 0.6 = 1.5

βX = 1.5/0.6 = 2.5

Check: If βX = 2.5 and βs = 1.5, the portfolio’s beta coefficient is:

βP = 0.4(1.5) + 0.6(2.5) = 2.1

 $40,000   $10,000 
8-11 new = 1.2   + 2.2  $40,000 + $10,000  = 1.2(0.8) + 2.2(0.2) = 1.4
 $40,000 + $10,000   

8-12 Information that is given:

Total current value $120,000

Number of stocks (current portfolio) 4
Beta coefficient, βCurrent 0.8

Because the beta coefficient for the portfolio will be 1.0 after the stock is sold for $48,000, we know that
the remaining stocks, which are worth $72,000 = $120,000 – $48,000, must have a weighted average
beta equal to 1.0. And, in combination, the weighted average beta for the stocks that make up the
current (pre-sale) portfolio must be 0.8, which means that the following situation must exist:

0.8 = ($48,000/$120,000)(Beta of stock being sold) + ($72,000/$120,000)(1.0)

0.8 = 0.40(βStock) + 0.60(1.0)

βStock = (0.8 – 0.6)/0.4 = 0.5

Check: βCurrent = ($48,000/$120,000)(0.5) + ($72,000/$120,000)(1.0) = 0.2 + 0.6 = 0.8

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accessible website, in whole or in part.
Chapter 8 CFIN4

8-13 Information that is given:

Total current value $200,000

Number of stocks (current portfolio) 6
Beta coefficient, βCurrent 1.5

Because the beta coefficient for the portfolio will be 1.3 after the stock is sold for $40,000, we know that
the remaining stocks, which are worth $160,000 = $200,000 – $40,000, must have a weighted average
beta equal to 1.3. And, in combination, the weighted average beta for the stocks that make up the
current (pre-sale) portfolio must be 1.5, which means that the following situation must exist:

1.5 = ($40,000/$200,000)(Beta of stock being sold) + ($160,000/$200,000)(1.3)

1.5 = 0.20(βStock) + 0.80(1.3)

βStock = (1.5 – 1.04)/0.2 = 2.3

Check: βCurrent = ($40,000/$200,000)(2.3) + ($160,,000/$200,000)(1.3) = 0.46 + 1.04 = 1.5

8-14 rRF = 3%
RRM = 6%
β = 1.5

r = 3% + (6%)1.5 = 12%

8-15 rRF = 4%
rM = 12%
β = 2.5

r = 4% + (12% - 4%)2.5 = 24%

8-16 rRF = ?
rM = 12.5%
β = 0.8
rZR = 11%

11% = rRF + (12.5% - rRF)0.8

11% = rRF +12.5%(0.8) – 0.8rRF

rRF = (11% - 10.0%)/0.2 = 5%

Check: If rRF = 5%, rZR = 5% + (12.5% - 5%)0.8 = 11%

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Chapter 8 CFIN4

8-17 rRF = 5%
rM = 11%
βV = 2.0
βW = 0.5

rV = 5% + (11% - 5%)2.0 = 17%

rW = 5% + (11% - 5%)0.5 = 8%

The required return for Stock V is 9% = 17% - 8% higher than the required return for Stock W.

8-18 Original information:

rQ = 11%
rRF = 4%
rM = 9%

Based on this information, we can compute the stock’s beta coefficient:

rQ = 11% = 4% + (9% - 4%)βQ

βQ = (11% - 4%)/5% = 1.4

Original RPM = 9% - 4% = 5%

Correct RPM = 5% + 1% = 6%

Correct rQ = 4% + (6%)1.4 = 12.4%

8-19 Given information:

rRF = 3.5%
RPM = 7%
βU = 0.9
P0 = $28
D0 = $1.75
g = 4%

Stock U’s required rate of return is rU = 3.5% + 7%(0.9) = 9.8%

Stock U’s expected rate of return is:

$1.75(1.04)
r̂U = + 0.04 = 0.105 = 10.5%
$28

In this case, the expected rate of return, r̂U , is greater than the required rate of return, rU, which means
the $28 selling price is too low. Investors should want to buy the stock, which will increase the price of
the stock to its equilibrium value of $31.38:

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Chapter 8 CFIN4

$1.75(1.04) $1.82
P̂0 = = = $31.38
0.098 − 0.04 0.058

8-20 Given information:

P0 = $37.50
D0 = $2
rRF = 4%
rM = 10%
βStock = 1.1

rStock = 4% + (10%- 4%)1.1 = 10.6%

Based on the dividend discount model, we know the following relationship exists:

$2(1 + g)
$37.50 =
0.106 − g

Solving for g, gives the following result:

$2(1 + g)
$37.50 =
0.106 − g

$37.50(0.106 − g) = $2 + $2g

$3.975 − $37.50g = $2 + $2g

$39.50g = $1.975

$1.975
g= = 0.05 = 5.0%
$39.50

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accessible website, in whole or in part.