RISK, RETURN, AND CAPITAL BUDGETING

Q1) Risk and Return. True or False? Explain or qualify as necessary. a. Investors demand higher expected rate of return on stocks with more variable rate of return.

b. The capital asset pricing model predicts that a security with a beta of zero will provide an expected rate of return zero.

c. An investor who puts $10,000 in treasury bill and $20,000 in market portfolio will have a portfolio beta of 2.0

d. Investors demand higher expected rates of return from stocks with returns that are highly exposed to macroeconomic changes.

e. Investors demand higher expected rate of return from stock with return that are very sensitive to fluctuations in the stock market.

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Q2) CAPM and Expected Return. If the risk-free rate is 6 percent and the expected rate of return on the market portfolio is 14 percent, is a security with a beta of 1.25 and an expected rate of return of 16 percent overpriced or underpriced?

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Q3) Unique vs. Market Risk. The figure below shows plots of monthly rates of return on three stocks versus the stock market index. The beta and standard deviation of each stock is given beside its plot.

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a. Which stock is riskiest to a diversified investor?

b. Which stock is riskiest to an undiversified investor who puts all her funds in one of these stocks?

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c. Consider a portfolio with equal investments in each stock. What would this portfolios beta have been?

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d. Consider a well-diversified portfolio made up of stocks with the same beta as Exxon. What are the beta and standard deviation of this portfolios return? The standard deviation of the market portfolios return is 20 percent.

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e. What is the expected rate of return on each stock? Use the capital asset pricing model with a market risk premium of 8 percent. The risk-free rate of interest is 4 percent.

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Q4) Expected Returns. Consider the following two scenarios for the economy, and the returns in each scenario for the market portfolio, an aggressive stock A, and a defensive stock D. Rate of Return Aggressive Stock A Defensive Stock D -10% -6% 38% 24%

Scenario Bust Boom

Market -8% 32%

a. Find the beta of each stock. In what way is stock D defensive?

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b. If each scenario is equally likely, find the expected rate of return on the market portfolio and on each stock.

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c. If the T-bill rate is 4 percent, what does the CAPM say about the fair expected rate of return on the two stocks?

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d. Which stock seems to be a better buy based on your answers to (a) through (c)?

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Q5) CAPM and Valuation. A share of stock with a beta of .75 now sells for $50. Investors expect the stock to pay a year-end dividend of $2. The T-bill rate is 4 percent, and the market risk premium is 8 percent. If the stock is perceived to be fairly priced today, what must be investors expectation of the price of the stock at the end of the year?

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