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Risk

You are given the following returns on the Market and on Stock A. Calculate Stock A's beta coefficient.

Year 2005 2006 2007

Market -5.00% 11.00% 25.00%

Stock A -15.00% 12.00% 40.00%

a. b. c. d. e.
ii

1.74 1.83 1.92 2.02 2.12

Hocking Manufacturing Company has a beta of 0.65, while Levine Industries has a beta of 1.40. The required return on the stock market is 11.00%, and the riskfree rate is 4.25%. What is the difference between Hocking's and Levine's required rates of return? (Hint: First find the market risk premium, then find the required returns on the stocks.)

a. b. c. d. e.
iii

4.12% 4.34% 4.57% 4.81% 5.06%

. Millar Motors has a beta of 1.30 and an expected dividend growth rate of 5.00% per year. The T-bill rate is 3.00%, and the T-bond rate is 6.00%. The annual return on the stock market during the past 3 years was 15.00%. Investors expect the annual future stock market return to be 12.00%. Using the SML, what is Millar's required return?

a. b. c. d. e.
iv

12.5% 12.8% 13.1% 13.5% 13.8%

You have the following data on (1) the average annual returns of the market for the past 5 years and (2) similar information on Stocks A and B. Which of the possible answers best describes the historical betas for A and B?

Years 1 2 3 4 5

Market 0.03 -0.05 0.01 -0.10 0.06

Stock A 0.16 0.20 0.18 0.25 0.14

Stock B 0.05 0.05 0.05 0.05 0.05

a. bA > 0; bB = 1. b. bA > +1; bB = 0. c. bA = 0; bB = -1. d. bA < 0; bB = 0. e. bA < -1; bB = 1.

(7.5) Beta calculation Which of the following statements is CORRECT?

Answer: c

MEDIUM

a. The typical R2 for a stock is about 0.3 and the typical R2 for a portfolio is also about 0.3. b. The typical R2 for a stock is about 0.94 and the typical R2 for a portfolio is about 0.6.

c. The typical R2 for a stock is about 0.3 and the typical R2 for a large portfolio is about 0.94. d. The typical R2 for a stock is about 0.94 and the typical R2 for a portfolio is also about 0.94. e. The typical R2 for a stock is about 0.6 and the typical R2 for a portfolio is also about 0.6.

vi

Consider the following information and then calculate the required rate of return for the Scientific Investment Fund, which holds 4 stocks. The markets required rate of return is 15.0%, the risk-free rate is 7.0%, and the Fund's assets are as follows:

Stock A B C D

Investment $ 200,000 300,000 500,000 1,000,000

Beta 1.50 -0.50 1.25 0.75

a. 10.67% b. 11.23% c. 11.82% d. 12.45% e. 13.10%

(7.5) Required rate of return


vii

Answer: a

MEDIUM

Data for Oakdale Furniture, Inc. is shown below. Now the expected inflation rate and thus the inflation premium increase by 2.0 percentage points, and Oakdale acquires risky assets that increase its beta by the indicated percentage. What is the firm's new required rate of return?

Beta: Required return (rs) RPM: Percentage increase in beta:

1.50 10.20% 6.00% 20%

a. 14.00% b. 14.70% c. 15.44% d. 16.21% e. 17.02%

i.

(6.4) Calculating betas

Answer: b

MEDIUM

betaA = 1.83 Calculated with Excel, but could also be calculated with a calculator.
ii. (6.5) CAPM Answer: e MEDIUM

Beta: Hocking Beta: Levine Market return Risk-free rate Market risk premium Required return: Hocking Required return: Levine Difference
iii.

0.65 1.40 11.00% 4.25% 6.75% 8.64% 13.70% 5.06%


Answer: e MEDIUM

Intermediate step Intermediate step Intermediate step

(6.5) Required return on stock

Use CAPM to determine the market risk premium: rs = rRF + RPM bMarket 12.00% = 6.00% + RPM 1.00 6.00% = RPM

Use CAPM to determine Millar's required return using RPM calculated above rs = rRF + RPM bMillar rs = 6.00% + 6.00% rs = 13.80%
iv. (7.5) Beta coefficient Answer: d MEDIUM

1.30

Bs returns are independent of the market, hence its beta is zero. If you plot As returns against those of the market, you see a negative slope, hence Bs beta is negative. Therefore, d is the correct answer.

v.

(7.5) Beta calculation

Answer: c

MEDIUM

vi.

(7.5) Required rate of return

Answer: e

MEDIUM

rM: rRF:

15.0% 7.0%

Find portfolio beta: $200,000 $300,000 $500,000 $1,000,000 $2,000,000

Weight 0.100 0.150 0.250 0.500 1.000

Beta 1.50 -0.50 1.25 0.75

Product 0.1500 -0.0750 0.3125 0.3750 0.7625

Find RPM = rM rRF = 8.00% rs = rRF + b(RPM) = 13.10%

vii.

(7.5) Required rate of return

Answer: a

MEDIUM

Old beta: Old rs = rRF + b(RPM) RPM

1.50 10.20% 6.00%

Percentage increase in beta: 20%

Find new beta after increase = 1.80 Find old rRF: Old rs = rRF + b(RPM): 10.2% = rRF + 1.5(6.0%): rRF = 10.2% 9.0% = 1.20% Find new rRF: Old rRF + 2.0% increase in inflation = 3.20% Find new rs = new rRF + new beta(RPM) = 14.00%