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8-6 EXPECTED RETURNS Stocks X and Y have the following probability distributions of
expected future returns:
Probability X Y Probability*X Probbility*Y
0.1 -10 -35 -1 -3.5
0.2 2 0 0.4 0
0.4 12 20 4.8 8
0.2 20 25 4 5
0.1 38 45 3.8 4.5
12 14

a. Calculate the expected rate of return, ^rY, for Stock Y (^rX 12%).
b. Calculate the standard deviation of expected returns, _x0002_X, for Stock X (_x0002_Y 20.35%).
Now calculate the coefficient of variation for Stock Y. Is it possible that most investors
will regard Stock Y as being less risky than Stock X? Explain.

a. Calculate the expected rate of return, ^rY, for Stock Y (^rX 12%).

^Ry 14%
^rX 12%

b. Calculate the standard deviation of expected returns, _x0002_X, for Stock X (_x0002_Y 20.35%).

Standard Deviation of Expected Return for X

^rX 12

Probability X r-^R
0.1 -10 22 484 48.4
0.2 2 10 100 20
0.4 12 0 0 0
0.2 20 -8 64 12.8
0.1 38 -26 676 67.6

SUM 148.8
STD Dev 12.19836055
STD DEV X 12.21%
STD DEV Y 20.35%

CV-x 1.02
CV-y 1.45
No. Since STD DEV and CV for Stock Y is high it is more risky than Stock X.
^ry 14

Probability Y r-^R
0.1 -35 49 2401 240.1
0.2 0 14 196 39.2
0.4 20 -6 36 14.4
0.2 25 -11 121 24.2
0.1 45 -31 961 96.1

SUM 414
STD Dev 20.34699
 r-^r
p r 12.4
0.1 -27 -39.4 1552.36
0.2 -7 -19.4 376.36
660.4 0.4 15 2.6 6.76
0.2 30 17.6 309.76
0.1 45 32.6 1062.76

Y 20.00933
-35
0
20 20.03597
25
45 p r 10.5
0.1 -17 -29.4 864.36
0.2 -3 -15.4 237.16
0.4 10 -2.4 5.76
0.2 25 12.6 158.76
0.1 38 25.6 655.36

15.54799
 155.236 14.6
75.272
2.704
61.952
106.276

401.44
20.03597

86.436
47.432
2.304
31.752
65.536

233.46
15.2794
PORTFOLIO REQUIRED RETURN Suppose you are the money manager of a $4 million
investment fund. The fund consists of four stocks with the following investments and betas:

Stock Investment Beta Weight Por Ri=rRF+(rM-rRF)bi

A 400,000 1.5 0.10 0.15 18
B 600,000 -0.5 0.15 (0.08) 2
C 1,000,000 1.25 0.25 0.31 16
D 2,000,000 0.75 0.50 0.38 12
4,000,000 1.00 0.76

If the markets required rate of return is 14% and the risk-free rate is 6%, what is the funds
required rate of return?

MRP 14%
RFR 6%

Portfolio's Retutn
Ri=rRF+(rM-rRF)bi
bP 0.76
12.08

The Portfolio Required Rate of Return in 12.08%

REQUIRED RATE OF RETURN Stock R has a beta of 1.5, Stock S has a beta of 0.75, the
expected rate of return on an average stock is 13%, and the risk-free rate of return is 7%. By
how much does the required return on the riskier stock exceed the required return on the
less risky stock?

Beta Bi*Rpm
Stock R 1.5 9 9
Stock S 0.75 4.5

RFR 7
RM 13

RPM-(rm-rrf) 6

Ri for Stock R 16
Ri for Stock S 11.5

4.5%The required return on the riskier stock exceed the required return on the less risky stock by 4.5 %
CAPM AND REQUIRED RETURN Calculate the required rate of return for Manning Enterprises
assuming that investors expect a 3.5% rate of inflation in the future. The real risk-free
rate is 2.5%, and the market risk premium is 6.5%. Manning has a beta of 1.7, and its
realized rate of return has averaged 13.5% over the past 5 years.

IP 3.5
RRF 2.5
R*RF 6.0
MRP 6.5
RPm 11.05
Beta 1.7

Ri=rRF+(rM-rRF)bi 17.1

Expected Return 13.5

Required Return 6.9

The stock is undervalued.