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FIN 105 Chapter 8

1) The document discusses concepts from portfolio theory including required rate of return, beta coefficient, security market line, and CAPM. It provides examples of calculating portfolio beta, required returns for different companies and investments based on their beta. 2) A key point is that using the CAPM and security market line, an investor can determine the required rate of return for a potential investment based on the investment's beta and the market risk premium. 3) The document calculates that the required rate of return for one potential investment is 16.5% but the expected return is only 15%, so the investor should not make that investment.

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Arissa Kitchy Mababa Dy
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183 views3 pages

FIN 105 Chapter 8

1) The document discusses concepts from portfolio theory including required rate of return, beta coefficient, security market line, and CAPM. It provides examples of calculating portfolio beta, required returns for different companies and investments based on their beta. 2) A key point is that using the CAPM and security market line, an investor can determine the required rate of return for a potential investment based on the investment's beta and the market risk premium. 3) The document calculates that the required rate of return for one potential investment is 16.5% but the expected return is only 15%, so the investor should not make that investment.

Uploaded by

Arissa Kitchy Mababa Dy
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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FIN 105 C 

170790 
CHAPTER 8 
(8-7 to 8-10, 8-13 to 8-17, 8-21) 
 
8-7 PORTFOLIO REQUIRED RETURN 
1. Portfolio beta 
bp = (3/10)(1.6) + (2/10)(0.9) + (5/10)(− 0.7)  
bp = 0.31  
2. Required rate of return 
rp = rRF + (rM − rRF )b  
rp = 4% + (12% − 4%)0.31  
rp = 0.0648 or 6.48%  
 
8-8 BETA COEFFICIENT 
At equilibrium, rjˆ = rj = 12.5% 
 
Since rj = rRF + (rM − rRF )b,  
12.5% = 4.5% + (10.5% − 4.5%)b  
b = 1.33  
 
8-9 REQUIRED RATE OF RETURN 
1. SML equation 
ri = 6% + (14% − 6%)bi  
J-Axis Co: rJ = 6% + (14% − 6%)1.2 = 15.6%  
YSL Co: rY = 6% + (14% − 6%)0.7 = 11.6%  
 
J-Axis Co. exceeds YSL Co. by 4% 
 
8-10 CAPM AND REQUIRED RETURN 
1. Market risk premium 
Since an index fund has a beta of 1.0 and RP M = rM − rRF , 
r = rRF + (RP M )b  
12% = 5% + (RP M )1.0  
RP M = 7%  
2. Bradford Manufacturing Company 
rB = 5% + 7%(1.45)  
rB = 15.15%  
3. Farley Industries 
rF = 5% + 7%(0.85)  
rF = 10.95%  
Bradford’s required return exceeds Farley’s by 4.2% 
 
 
8-13 CAPM, PORTFOLIO RISK, AND RETURN 
a. Market risk premium rM − rRF  
Using Stock X, 
9% = 5.5% + ( rM − rRF ).8 
(rM − rRF ) = 4.375% 
b. Beta of Fund Q 
bQ = 0.8(1/3) + 1.2(1/3) + 1.6(1/3)  
bQ = 1.2  
c. Required return of Fund Q 
rQ = 5.5% + 4.375%(1.2)  
rQ = 10.75%  
 
8-14 PORTFOLIO BETA 
Since there are 20 stocks, each has a weight of 5% 
Old portfolio beta = 1.12 = (∑ bi)(0.05) ; ∑ bi = 22.4  
New portfolio beta = (22.4 - 1.0 + 1.75)(0.05) = 1.1575 ~ 1.16 
 
 
8-15 CAPM AND REQUIRED RETURN 
1. Beta (no changes) 
bAM = 1.4 , bP M = 0.7  
2. rM : 12% (falls to 12% from 16%), rRF : 7%-2% = 5% (falls 2% from 7% to 5%) 
3. SML Equation: ri = 5% + (12% − 5%)bi  
4. AM Inc: ri = 5% + (12% − 5%)1.4 = 14.8%  
5. PM Inc: ri = 5% + (12% − 5%)0.7 = 9.9%  
 
The difference between AM Inc and PM Inc is 4.9% 
 
 
8-16 CAPM AND PORTFOLIO RETURN 
1. Market risk premium 
0.23 = 0.0525 + ( rM − rRF )1.25  
(rM − rRF ) = 0.054  
2. New portfolio beta 
(500,000/5,500,000)(0.75)+(5,000,000/5,500,000)(1.25) = 1.2045 
3. Required return on new portfolio 
5.25% + (5.4%)(1.2045) = 11.75% 
 
8-17 PORTFOLIO BETA 
1. Required beta to have an expected return of 16% 
16% = 4% + (7%)b  
b = 1.7143 
2. Required beta for the additional investment 
1.7143 = (10, 000, 000)(1.3)/15, 000, 000 + (5, 000, 000)(x)/15, 000, 000  
x = 2.5429 ~ 2.5 
 
The average beta of the new stocks should be 2.5   
 
8-21 SECURITY MARKET LINE 
a. Equation for the security market line (SML) 
1. Expected market return 
ˆr
M = 0.1(−28%) + 0.2(0%)+ 0.4(12%) + 0.2(30%) + 0.1(50%) = 13%  
2. SML equation: ri = rRF + (rM − rRF )bi  
ri = 6% + (13% − 6%)bi  
 
b. Required rate of return 
1. Weights of each stock 
A = 160/500 = 0.032 
B = 120/500 = 0.24 
C = 80/500 = 0.16 
D = 80/500 = 0.16 
E = 60/500 = 0.12 
2. Beta 
bF = 0.32(0.5) + 0.24(1.2) + 0.16(1.8) + 0.16(1..0) + 0.12(1.6)  
bF = 1.088  
3. Required rate of return 
ri = 6% + (13% − 6%)1.088  
ri = 13.616%  
 
c. Required/expected rate of return 
ˆr = 6% + (7%)1.5 = 16.5%  
N
 
Since the expected return of the stock is 15%, lower than the required rate of return of 16.5%, Kish shouldn’t 
invest in the stock. The expected rate of return should be 16.5% for Kish to be indifferent to purchasing the 
stock 

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