Financial Management

Required rate of return 0.2 2 0

Assume that the risk-free rate is 6 percent and the expected 0.4 12 20
return on the market is 13 percent. What is the required rate 0.2 20 25
of return on a stock with a beta of 0.7? 0.1 38 45

Expected and required rates of return a. Calculate the expected rate of return.
Assume that the risk-free rate is 5 percent and the market b. Calculate the standard deviation of expected returns.
risk premium is 6 percent. What is the expected return for
the overall stock market? What is the required rate of return Portfolio beta
on a stock with a beta of 1.2? An individual has P35,000 invested in a stock with a beta of
0.8 and another P40,000 invested in a stock with a beta of
Required rate of return 1.4. If these are the only two investments in her portfolio,
Stock R has a beta of 1.5, Stock S has a beta of 0.75, the what is her portfolio’s beta?
expected rate of return on an average stock is 13 percent, and
the risk-free rate of return is 7 percent. By how much does Portfolio beta
the required return on the riskier stock exceed the required A mutual fund manager has a P20,000,000 portfolio with a
return on the less risky stock? beta of 1.5. The risk-free rate is 4.5 percent and the market
risk premium is 5.5 percent. The manager expects to receive
Beta and required rate of return an additional P5,000,000, which she plans to invest in a
A stock has a required return of 11 percent; the risk-free rate number of stocks. After investing the additional funds, she
is 7 percent; and the market risk premium is 4 percent. wants the fund’s required return to be 13 percent. What
should be the average beta of the new stocks added to the
a. What is the stock’s beta? portfolio?
b. If the market risk premium increased to 6 percent, what
would happen to the stock’s required rate of return? Portfolio required return
Assume the risk-free rate and the beta remain Suppose you are the money manager of a P4 million
unchanged. investment fund. The fund consists of 4 stocks with the
following investments and betas:
Beta coefficient Stock Investment Beta
Given the following information, determine the beta A P400,000 1.50
coefficient for Stock J that is consistent with equilibrium: r = B 600,000 1.25
12.5%; rf = 4.5%; rm = 10.5%. C 1,000,000 1.25
D 2,000,000 0.75
Expected return, Standard deviation, Coefficient of
variation If the market’s required rate of return is 14 percent and the
A stock’s returns have the following distribution: risk-free rate is 6 percent, what is the fund’s required rate of
Demand for the Rate of Return If return?
Company’s Probability of This This Demand
Products Demand Occurring Occurs Revised portfolio beta
Weak 0.1 (50%) Suppose you held a diversified portfolio consisting of a
Below average 0.2 (5) P7,500 investment in each of 20 different common stocks.
Average 0.4 16 The portfolio’s beta is 1.12. Now suppose you decided
Above average 0.2 25 to sell one of the stocks in your portfolio with a beta of 1.0 for
Strong 0.1 60 P7,500 and to use these proceeds to buy another stock with a
1.0 beta of 1.75. What would your portfolio’s new beta be?

Calculate the stock’s expected return, standard deviation, and CAPM and required return
coefficient of variation. HR Industries (HRI) has a beta of 1.8, while LR Industries’
(LRI) beta is 0.6. The risk-free rate is 6 percent, and the
Expected return, Standard deviation, Coefficient of required rate of return on an average stock is 13 percent.
variation Now the expected rate of inflation built into rRF falls by 1.5
Stocks X and Y have the following probability distributions of percentage points, the real risk-free rate remains constant,
expected future returns: the required return on the market falls to 10.5 percent, and
Probability X Y all betas remain constant. After all of these changes, what will
0.1 (10%) (35%) be the difference in the required returns for HRI and LRI?

Investment risk and return 1

Financial Management

CAPM and required return each year? What would the average return on the
Bradford Manufacturing Company has a beta of 1.45, while portfolio have been during this period?
Farley Industries has a beta of 0.85. The required return on c. Calculate the standard deviation of returns for each stock
an index fund that holds the entire stock market is 12.0 and for the portfolio.
percent. The risk-free rate of interest is 5 percent. By how d. Calculate the coefficient of variation for each stock and
much does Bradford’s required return exceed Farley’s for the portfolio.
required return? e. Assuming you are a risk-averse investor, would you
prefer to hold Stock A, Stock B, or the portfolio? Why?
CAPM and required return
Calculate the required rate of return for Manning Enterprises, Comprehensive problem
assuming that investors expect a 3.5 percent rate of inflation You plan to invest in the Kish Hedge Fund, which has total
in the future. The real risk-free rate is 2.5 percent and the capital of P500 million invested in five stocks:
market risk premium is 6.5 percent. Manning has a beta of Stock Investment Stock’s Beta Coefficient
1.7, and its realized rate of return has averaged 13.5 percent A P160,000,000 0.5
over the past 5 years. B 120,000,000 2.0
C 80,000,000 4.0
CAPM and market risk premium D 80,000,000 1.0
Consider the following information for three stocks, Stocks X, 60,000,000 3.0
Y, and Z. The returns on the three stocks are positively
correlated, but they are not perfectly correlated. (That is, Comprehensive problem
each of the correlation coefficients is between 0 and 1.) Stock X has a 10 percent expected return, a beta coefficient of
Stock Expected Return Deviation Beta 0.9 and a 35 percent standard deviation of expected returns.
X 9.00% 15% 0.8 Stock Y has a 12.5 percent expected return, a beta coefficient
Y 10.75 15 1.2 of 1.2, and a 25 percent standard deviation. The risk-free rate
Z 12.50 15 1.6 is 6 percent, and the market risk premium is 5 percent.

Fund P has half of its funds invested in Stock X and half a. Calculate each stock’s coefficient of variation.
invested in Stock Y. Fund Q has one-third of its funds b. Which stock is riskier for a diversified investor?
invested in each of the three stocks. The risk-free rate is c. Calculate each stock’s required rate of return.
5.5 percent, and the market is in equilibrium. (That is, d. On the basis of the two stocks’ expected and required
required returns equal expected returns.) What is the market returns, which stock would be more attractive to a
risk premium? diversified investor? Calculate the required return of a
portfolio that has P7,500 invested in Stock X and P2,500
CAPM and portfolio return invested in Stock Y. If the market risk premium increased
You have been managing a P5 million portfolio that has a to 6 percent, which of the two stocks would have the
beta of 1.25 and a required rate of return of 12 percent. The larger increase in its required return?
current risk-free rate is 5.25 percent. Assume that you
receive another P500,000. If you invest the money in a stock
with a beta of 0.75, what will be the required return on your
P5.5 million portfolio?

Comprehensive problem
Stocks A and B have the following historical returns:
Year Stock A returns Stock B returns
2001 (18.00%) (14.50%)
2002 33.00 21.80
2003 15.00 30.50
2004 (0.50) (7.60)
2005 27.00 26.30

a. Calculate the average rate of return for each stock during

the period 2001 through 2005.
b. Assume that someone held a portfolio consisting of 50
percent of Stock A and 50 percent of Stock B. What would
the realized rate of return on the portfolio have been in

Investment risk and return 2