Chapter 13 Problems Finance ll

1. You want your portfolio beta to be 1.10. Currently, your portfolio consists of $3,000 invested
in stock A with a beta of 1.65 and $2,000 in stock B with a beta of .72. You have another $5,000
to invest and want to divide it between an asset with a beta of 1.48 and a risk-free asset. How
much should you invest in the risk-free asset?

BetaPortfolio = 1.10 = ($3,000 / $10,000 × 1.65) + ($2,000 / $10,000 × .72) + (x / $10,000 × 1.48) +
(($5,000 - x) / $10,000 × 0) = .495 + .144 + .000148x + 0; .461 = .000148x; x = $3,114.86;
Risk-free asset = $5,000 - $3,114.86 = $1,885.14

2. You have a $9,000 portfolio which is invested in stocks A, B, and a risk-free asset. $4,000 is
invested in stock A. Stock A has a beta of 1.84 and stock B has a beta of 0.68. How much needs
to be invested in stock B if you want a portfolio beta of .95?

BetaPortfolio = .95 = ($4,000 / $9,000 × 1.84) + (x / $9,000 × .68) + [($9,000 - $4,000 - x) / $9,000
× 0)]; .95 = .817777778 + .000075556x + 0; .00007556x = .132222222; x = $1,750

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3. You recently purchased a stock that is expected to earn 16 percent in a booming economy, 12
percent in a normal economy, and lose 8 percent in a recessionary economy. There is a 20
percent probability of a boom, a 70 percent chance of a normal economy, and a 10 percent
chance of a recession. What is your expected rate of return on this stock?

E(r) = (.20 × .16) + (.70 × .12) + (.10 × -.08) = .032 + .084 - .008 = .108 = 10.8 percent

4. You are comparing stock A to stock B. Given the following information, which one of these
two stocks should you prefer and why?

E(r)A = (.70 × .11) + (.30 × .07) = .077 + .021 = .098 = 9.8 percent
E(r)B = (.70 × .19) + (.30 × -.12) = .133 - .036 = .097 = 9.7 percent. You should select stock A
because it has a higher expected return and also appears to be less risky.

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5. If the economy booms, Frank's Welding Supply stock is expected to return 19 percent. If the
economy falls into a recession, the stock's return is projected at 5 percent. The probability of a
boom is 80 percent while the probability of a recession is 20 percent. What is the variance of the
returns on this stock?

E(r) = (.80 × .19) + (.20 × .05) = .152 + .01 = .162

Var = .80 × (.19 - .162)2 + .20 × (.05 - .162)2 = .0006272 + .0025088 = .003136

6. The returns on the common stock of Cycles, Inc. are quite cyclical. In a boom economy, the
stock is expected to return 27 percent in comparison to 13 percent in a normal economy and a
negative 20 percent in a recessionary period. The probability of a recession is 30 percent while
the probability of a boom is 5 percent. The remainder of the time the economy will be at normal
levels. What is the standard deviation of the returns on this stock?

E(r) = (.05 × .27) + (.65 × .13) + (.30 × -.20) = .0135 + .0845 - .06 = .038
Var = .05 × (.27 - .038)2 + .65 × (.13 - .038)2 + .30 × (-.20 - .038)2 = .0026912 + .0055016 +
.0169932 = .025186Std dev = .025186 = .1587 = 15.87 percent

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7. What is the standard deviation of the returns on a stock given the following information?

E(r) = (.18 × .19) + (.76 × .12) + (.06 × -.15) = .0342 + .0912 - .009 = .1164
Var = .18 × (.19 - .1164)2 + .76 × (.12 - .1164)2 + .06 × (-.15 - .1164)2 = .000975053 + .00000985
+ .004258138 = .00524304
Std dev = .00524304 = .07241 = 7.24 percent

8. You have a portfolio consisting solely of stock A and stock B. The portfolio has an expected
return of 10.8 percent. Stock A has an expected return of 13 percent while stock B is expected to
return 8 percent. What is the portfolio weight of stock A?

.108 = [.13 × x] + [.08 × (1 - x)] = .13x + .08 - .08x; .028 =.05x; x = 56 percent

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9. You own the following portfolio of stocks. What is the portfolio weight of stock C?

Portfolio weightC = (100 × $31) / [(200 × $27) + (900 × $48) + (100 × $31) + (300 × $11)] =
$3,100 / $55,000 = 5.6 percent

10. You own a portfolio with the following expected returns given the various states of the
economy. What is the overall portfolio expected return?

E(r) = (.35 × .22) + (.60 × .13) + (.05 × -.45) = .077 + .078 - .0225 = .1325 = 13.25 percent

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11. What is the expected return on a portfolio which is invested 30 percent in stock A, 40 percent
in stock B, and 30 percent in stock C?

E(r)Boom = (.30 × .17) + (.40 × .10) + (.30 × .04) = .051 + .04 + .012 = .103
E(r)Normal = (.30 × .12) + (.40 × .08) + (.30 × .09) = .036 + .032 + .027 = .095
E(r)Bust = (.30 × - .10) + (.40 × .03) + (.30 × .15) = -.03 + .012 + .045 = .027
E(r)Portfolio = (.10 × .103) + (.75 × .095) + (.15 × .027) = .0103 + .07125 + .00405 = .0856 = 8.56
percent

12. What is the expected return on this portfolio?

Portfolio value = (750 × $33) + (220 × $51) + (460 × $19) = $24,750 + $11,220 + $8,740 =
$44,710; E(r) = ($24,750 / $44,710 × .09) + ($11,220 / $44,710 × .14) + ($8,740 / $44,710 × .12)
= .04982 + .03513 + .02346 = .10841 = 10.84 percent

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13. What is the portfolio variance if 55 percent is invested in stock S and 45 percent is invested
in stock T?

E(r)Boom = (.55 × .16) + (.45 × .18) = .088 + .081 = .169

E(r)Normal = (.55 × .12) + (.45 × .06) = .066 + .027 = .093
E(r)Portfolio = (.35 × .169) + (.65 × .093) = .05915 + .06045 = .1196
VarPortfolio = [.35 × (.169 - .1196)2] + [.65 × (.093 - .1196)2] = .000854126 + .000459914 =
.001314

14. What is the variance of a portfolio consisting of $5,500 in stock G and $4,500 in stock H?

E(r)Boom = [$5,500 / ($5,500 + $4,500) × .14)] + [$4,500 / ($5,500 + $4,500) × .11) = .077 +
.0495 = .1265
E(r)Normal = [$5,500 / ($5,500 + $4,500) × .07)] + [$4,500 / ($5,500 + $4,500) × .09) = .0385 +
.0405 = .079
E(r)Portfolio = (.22 × .1265) + (.78 × .079) = .02783 + .06162 = .08945
VarPortfolio = [.22 × (.1265 - .08945)2] + [.78 × (.079 - .08945)2] = .000301995 + .000085178 =
.000387173 = .000387

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15. What is the standard deviation of a portfolio that is invested 68 percent in stock Q and 32
percent in stock R?

E(r)Boom = (.68 × .17) + (.32 × .10) = .1156 + .032 = .1476

E(r)Normal = (.68 × .07) + (.32 × .08) = .0476 + .0256 = .0732
E(r)Portfolio = (.20 × .1476) + (.80 × .0732) = .02952 + .05856 = .08808
VarPortfolio = [.20 × (.1476 - .08808)2] + [.80 × (.0732 - .08808)2] = .000708526 + .000177132 =
.000885658
Std dev = .000885658 = .02976 = 3.0 percent

16. What is the standard deviation of a portfolio which is comprised of $9,000 invested in stock
S and $6,000 in stock T?

E(r)Boom = [$9,000 / ($9,000 + $6,000) × .11)] + [$6,000 / ($9,000 + $6,000) × .05) = .066 + .02 =
.086
E(r)Normal = [$9,000 / ($9,000 + $6,000) × .08)] + [$6,000 / ($9,000 + $6,000) × .06) = .048 +
.024 = .072
E(r)Bust =[$9,000 / ($9,000 + $6,000) × -.05)] + [$6,000 / ($9,000 + $6,000) × .08) = -.03 + .032
= .002
E(r)Portfolio = (.05 × .086) + (.85 × .072) + (.10 × .002) = .0043 + .0612 + .0002 = .0657
VarPortfolio = [.05 × (.086 - .06572)] + [.85 × (.072 - .0657)2] + [.10 × (.002 - .0657)2] = .000020605
+ .000033737 + .000405769 = .00046011
Std dev = .00046011 = .02145 = 2.1 percent

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17. What is the beta of a portfolio comprised of the following securities?

ValuePortfolio = $3,500 + $1,000 + $9,500 = $14,000

BetaPortfolio = ($3,500 / $14,000 × 1.12) + ($1,000 / $14,000 × 1.81) + ($9,500 / $14,000 × .84) =
.28 + .1293 + .57 = .9793 = .98

18. Your portfolio has a beta of 1.24. The portfolio consists of 10 percent U.S. Treasury bills, 55
percent in stock A, and 35 percent in stock B. Stock A has a risk-level equivalent to that of the
overall market. What is the beta of stock B?

The beta of a risk-free asset is zero. The beta of the market is 1.0.

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19. You would like to combine a risky stock with a beta of 1.68 with U.S. Treasury bills in such a
way that the risk level of the portfolio is equivalent to the risk level of the overall market. What
percentage of the portfolio should be invested in Treasury bills?

BetaPortfolio = 1.0 = [(1 - w) × 1.68] + [w × 0] = 1.68 - 1.68w; 1.68w = .68; w = .40

20. The market has an expected rate of return of 11.4 percent. The long-term government bond is
expected to yield 5.4 percent and the U.S. Treasury bill is expected to yield 4.6 percent. The
inflation rate is 3.9 percent. What is the market risk premium?

Risk premium = 11.4 percent - 4.6 percent = 6.8 percent

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21. The common stock of GO Limited has a beta of 1.23 and an expected return of 12.84 percent.
The risk-free rate of return is 4.2 percent. What is the expected return on the market?

E(r) = .1284 = .042 + 1.23 (rm - .042); .13806 = 1.23rm; rm = .1122 = 11.22 percent

22. The expected return on Joseph's Restaurant's stock is 14.25 percent while the expected return
on the market is 12.38 percent. The stock's beta is 1.18. What is the risk-free rate of return?

E(r) = .1425 = rf + 1.18 × (.1238 - rf); .18rf = .003584; rf = .0199 = 1.99 percent

23. The common stock of PDS has a beta of .98 and an expected return of 12.34 percent. The
risk-free rate of return is 4.1 percent and the market rate of return is 11.65 percent. Which one of
the following statements is true given this information?

E(r) = .041 + [.98 × (.1165 - .041) = .11499 = 11.50 percent; PDS stock is underpriced as its
actual expected return exceeds the expected return based on CAPM.

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24. Which one of the following stocks is correctly priced if the risk-free rate of return is 3.2
percent and the market risk premium is 8.4 percent?

E(r)A = .032 + (.72 × .084) = .0925

E(r)B = .032 + (1.46 × .084) = .1546
E(r)C = .032 + (1.38 × .084) = .1479 Stock C is correctly priced.
E(r)D = .032 + (1.01 × .084) = .1168
E(r)E = .032 + (.95 × .084) = .1118

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