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January 25, 2010

Case #84 Risk and Rates of Return Filmore Enterprises


ummary of Case Kathy Filgrade is the owner of Computer Products Corporation, a company that designs computer systems for its clients and has expanded to operate six mega-stores. Kathy is looking to expand the usiness to incorporate a cy er-caf! and has decided to partner with "andy #orely, who owns #orely $istri utors %a local e&erage distri utor'. Kathy and "andy oth ha&e the ma(ority of their finances tied up in their respecti&e usinesses, and ha&e asked for analysts to prepare a discussion on the risk and return issues surrounding this new usiness &enture. !uestion 1 Calculate the expected rate of return for each of the financial assets listed in Table 1, and complete the expected return row for Table 1. Based solely on the expected returns, which of the investments appears the best and worst? Discuss the impact on returns for general changes in the economy for C C, !orely, and "#T. Response" Returns on Alternative Investments Estimated Rates of Return Long-Run State of the Economy Recession Below Av Avera e A$ove Av Boom Pro b. 0.10 0.!0 0.40 0.!0 0.10 TTBills Bonds CPC Morely EAT 4.50 % 10.00% 18.00% 18.00% 13.00% 4.50 % ".00% -8.00% 14.00% -#.00% 4.50 % 5.00% 11.00% #.00% 10.00% 4.50 % 3.00% !#.00% -1.00% !0.00% 4.50 % !.00% 35.00% 11.00% 30.00% 4.50 % AS!A" #nde$ -13.00% -!.00% 11.00% 1".00% !!.00%

E%&ected Return

5.!0%

'."0%

5."0%

8.50%

8.30%

)ased solely on expected return, CPC has the highest expected return, whereas *)ills ha&e the lowest expected return for the in&estments. For CPC and +,*, the state of the economy has to e at least a&erage in order for there to e a positi&e return. -f the economy is elow a&erage or in a recession, these in&estments are expected to produce negati&e returns. CPC seems to ha&e the most risk in&ol&ed, due to the fact that it will

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lose the most during a recession and gain the most during a oom in the economy. #orely is the opposite, where a oom in the economy is expected to ha&e a negati&e rate of return, and a recession in the economy is expected to produce the in&estment2s largest gain.
!uestion # Basing a decision solely on expected returns is appropriate only for ris$%neutral individuals. &ince most people are ris$ averse, ris$ is an important consideration for the decision. a. Two possible measures of ris$ are the standard deviation and the coefficient of variation. Calculate the standard deviation and coefficient of variation for C C returns and complete the related blan$s in Table 1. Response" T-Bills E%&ected Return (ariance )td deviation *oef of (ar +*(, 4.50% 0.00 0.00% 0.00 TBonds 5.!0% 5.00 !.!3% 0.43 CPC '."0% !5".!1 1#.04% 1.#5 Morely 5."0% #5.80 8.11% 1.4! EAT 8.50% 1#1.'0 1!."!% 1.50 AS!A " #nde$ 8.30% 103.40 10.1"% 1.!3

b. Compare the ris$ and expected return relationships among all six assets listed in Table 1 'ma$e a table(. "xplain the apparent discrepancies with the normal ris$ and return tradeoff. Response" ee ta$le a$o%e&

3enerally, the higher the risk, the higher the return is expected to e. CPC has the highest expected return, ut it also has the highest standard de&iation and highest coefficient of &ariation. *he #orely rates are uncharacteristic, ecause the in&estment expects minimal returns during an a&erage state in the economy, which has the highest pro a ility weight. *his contri utes to the in&estment ha&ing a higher coefficient of &ariation, indicating more return per unit of risk than the 4,5$,6 -ndex, which has a higher return. *he coefficient of &ariation is a useful figure in that it shows the return per unit of risk and allows for etter comparison of different alternati&es %+hrhardt, 788/'.
!uestion 4 &uppose investors create a )%stoc$ portfolio by investing *1++,+++ in C C and *1++,+++ in !orely. a. Calculate the expected return for each state of the economy, and the compute the expected return for the portfolio. Complete the related blan$s in Table ). Response" Returns on Portfolios Portfolio %&'CPC Long-Run State of %&' (&'CPC %&' Morely the Economy Prob. Morely )&' EAT %&'EAT Recession 0.10 0.00% -15.00% !.50% Below Av 0.!0 3.00% -#.80% 4.00%

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Avera e A$ove Av Boom E%&ected Return (ariance )td deviation *oef of (ar +*(,

0.40 0.!0 0.10

8.50% 1!.50% 1!.00% "."0%

10.40% !!.40% 3!.00% 8.'8%

8.00% '.50% '.50% ".10% !.4"%

1".0# 1'".10 #.10 4.13% 14.04% 0.54 1.5# 0.35

b. Compute the standard deviation for the portfolio, and compare it to the standard deviation of the individual stoc$s. Complete the related blan$s in Table ). Response" ee ta$le a$o%e&

*he standard de&iation for the portfolio is significantly lower than oth of the indi&idual stocks2 standard de&iations. *his signifies there has een some di&ersification, lowering the risk of in&estment for the portfolio.
c. ,n general, how would ris$ be affected if you formed another portfolio composed of C C and "#T? "xplain how the correlation coefficient affects the level of diversification in the C C% !orely and the C C%"#T portfolios. Response"

*he standard de&iation is higher when com ining CPC and +,*. *he risk is not eing di&ersified well, ecause the companies are more highly correlated. 9ith CPC and #orely, the portfolio is well di&ersified due to the fact that #orely has a high positi&e return expected during a recession whereas CPC has a high positi&e return expected during an economic oom. *hus CPC and #orely are highly negati&ely correlated and pro&ide for decreased risk and a lower standard de&iation.
!uestion 5 &uppose an investor has a portfolio consisting of -ust one randomly%selected stoc$. .hat happens to the ris$ as the investor adds more and more randomly%selected stoc$s to the portfolio? ,llustrate your answer with a graph showing /portfolio standard deviation0 on the vertical axis and /number of stoc$s0 on the hori1ontal axis. Response"

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,s you increase the num er of stocks, you are a le to decrease the standard de&iation. *his gi&es the portfolio considera ly less risk if enough stocks are uilt into the portfolio. *he standard de&iation decreases y a lesser degree with each stock added, so the portfolio manager needs to decide at which point increasing the num er of stocks no longer pro&ides enough enefit towards lowering risk. ,s you can see y the graphical representation, as the num er of stocks increase on the x axis, the slope of the line egins to le&el out. *he highest degrees of change are near the eginning when dealing with only a few stocks, whereas adding stocks after reaching (ust 1; stocks has a fairly minimal degree of change in comparison. !uestion ' Change Table 1 by substituting 2ear 1 through 2ear 3 for the states of the economy. a. lot the characteristic lines for C C, !orely, and T%bills showing the returns on the index 'the mar$et( on the x%axis and the returns on the asset on y%axis. "stimate 'by visual inspection( the slope for each line. ,f you are using the spreadsheet model, compute the slope coefficients. 4ow do these compare to the betas provided in Table 1? Response" AS!A AS!A AS!A " " " T-Bills #nde$ Slo*e CPC #nde$ Slo*e Morely #nde$ Slo*e 18.00 4.50% 13.00% 0 % 13.00% 1.534 18.00% 13.00% -0.""5 4.50% -!.00% -8.00% -!.00% 14.00% -!.00% 11.00 4.50% 11.00% % 11.00% #.00% 11.00% !#.00 4.50% 1".00% % 1".00% -1.00% 1".00% 35.00 4.50% !!.00% % !!.00% 11.00% !!.00%
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*he slope coefficients are &ery close to that of the etas in *a le 1. *hey are accurate to the hundredth decimal as pro&ided in the ta le. b. .hat is the significance of the distance between the plot points and the regression line, that is, the errors? Response" *he distance is the &ariance in the return of the stocks from the market. *he stock does not perform exactly as the market does, ut rather mo&es up and down due to the fact that the stock might do etter or worse than the market and any gi&en point in time. c. .hat do betas measure, and how are they used in ris$ analysis? Response" )eta measures the relati&e risk of an indi&idual stock %+hrhardt, 788/' *he stock with a&erage risk is said to ha&e a eta of 1. , stock elow this will tend to fluctuate less than the market with mo&ements in the market, and a stock that has a eta greater than 1 will tend to fluctuate more than the market. <r in other words, a stock with a coefficient of 8.; is said to e half as risky as the market %+hrhardt, 788/'. d. Develop a table depicting the beta and expected return for each security, determined from the data provided by the investment ban$ers. Does the ris$ and return relationship appear reasonable relative to the mar$et? Response" Security Ris+ , Return Beta E$*ected Return T-Bills 0.00 4.50% T-Bonds -0.!! 5.!0% CPC 1.53 '."0% Morely -0."" 5."0% EAT 1.!! 8.50% *he eta and expected return for the market are 1.88 and /.:8= respecti&ely. *he risk and return relationship does appear to e reasona le relati&e to the market. -n the ta le a o&e, oth CPC and +,* ha&e a higher eta than the market, and are expecting higher returns than the market. *hose that ha&e a eta elow the market also ha&e a return elow the market2s return. !uestion 8 5sing T%bonds as a ris$%free rate and the 6#&D#7 index as the mar$et, a. lot the &ecurity !ar$et 8ine '&!8(. Response"

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b. Calculate the re9uired rate of return for C C, !orely, and "#T based on the &!8. Compare the re9uired return from the &!8 with the expected return from 7uestion 1. "xplain the decision to either buy or sell each of the stoc$s, give this information. Response" () E*uation" k + kRF , -k( kRF.$ SML E-. E$* Rate *-* . '.'4% '."0% /orel0 . !.81% 5."0% EA1 . 8.'8% 8.50% 3i&en this information - would not uy the CPC or +,* stocks, as it shows that they oth are elow the 5#>. *his indicates the stock is not earning enough of a return ased on the gi&en le&el of risk. - would uy the #orely stock, ecause it is a o&e the line, indicating that it is earning more than its re?uired return for its le&el of risk. c. #re the stoc$s in e9uilibrium? ,f not, how would e9uilibrium be restored? Response" *he stocks are not in e?uili rium. -n order to restore e?uili rium, the stocks elow the line would ha&e to either lower the le&el of risk in relation to the market or increase the expected return of that stock to match the re?uired return. For a stock a o&e the line, e?uili rium would ha&e to e restored y decreasing the return ack to the market2s le&el of return or the risk would need to increase to match its point on the 5#>. For stocks, this is determined y the usiness acti&ities of the corporation it represents. -n&estors look to take ad&antage of stocks that will produce higher returns than the re?uired return ased on the 5#>. *hese forces contri ute to esta lishing a stock2s e?uili rium in the market. , stock may also e underpriced or o&erpriced in the market, ut trading on the open market will generally mo&e the stock ack to its true &alue in the market, or e?uili rium. !uestion / :ilmore "nterprises is expected to be similar to a company composed of ;+< C C and =+< "#T.

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a. Compute the beta coefficient for a ;+>=+ portfolio of C C%"#T and then determine its re9uired rate of return. 4ow does the re9uired return compare with the expected return from Table )? "xplain why you would or would not purchase this portfolio. Response" -f you plot the stock2s returns on the y-axis and the market portfolio returns on the x-axis, the slope will e e?ual to the eta. Calculating this slope with excel gi&es us 1.:0@ for the eta. *his is using *-)onds for the k"F and the 4,5$,6 index for the k#. 1.34#4"!0 )lo&e . ! Re2 r . 3R4 5 +3/ - 3R4,$ Re2 r . '.3"% *he re?uired return is higher than the expected return. - would not purchase this portfolio. *he portfolio may look like a good option, ecause the expected return at /.A/= is still higher than the market2s expected return at /.:8=. Bowe&er, it is not a good in&estment, ecause the re?uired return for the amount of risk in&ol&ed is higher than the expected return on the portfolio. !uestion 10 The &!8 might shift in response to various economic changes. # change in the &!8 affects security prices and rates of return. a. &uppose investors raised their expectations for inflation by ; percentage points over current estimates as reflected in the 3.)< T%bond rate. "xplain the effect this would have on the &!8 and on the returns re9uired on high ?versus low%ris$ securities. Response" *he increase will shift the 5#> upwards, there y increasing the re?uired rates of return for a gi&en amount of risk. ,t any gi&en eta, the corresponding re?uired rate of return would increase y 0=. . . .the increase in r"F leads to an e?ual increase in the rate of return on all risky assets, ecause the same inflation premium is uilt into the re?uired rate of return %+hrhardt, 788/'. b. Disregard 7uestion 1+a and assume that investor@s ris$ aversion increased enough to cause the mar$et ris$ premium to rise by ; percentage points. "xplain what effect this would have on the &!8 and on returns of high%ris$ versus low%ris$. Response" *his will increase the slope on the 5#>. , higher market risk premium will cause highrisk securities to increase y a greater degree than low-risk securities. *hus, the returns on highrisk securities will increase y a greater degree as well. c. Discuss the $inds of changes 7uestion 1+a and 1+b would have on short%run and long%run effectsA for example, might an increase in expected inflation lead to lower returns in the short run followed by higher returns in the long run? Response" -n 18a, we saw an increase in inflation. *his could lead to lower returns in the short run as the market needs time to ad(ust. <nce the market ad(usts, it could pro&ide greater returns in the long run with the same amount of risk, ecause the entire 5#> is shifted upwards. -n 18 , we saw an increase in the market risk premium. -n the short run, in&estors may e getting lower returns for their le&el of risk. -n the long run, in&estors could get a higher rate of

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return for the same le&el of risk. ,lso, in the long run, in&estors may egin to in&est in riskier securities due to the fact that the slope has increased for the 5#>, which will pro&ide a greater increase in return for the higher risk securities &ersus the lower risk securities. Re0ommendation" )ased on the calculations that were conducted we can see that among all the proposed portfolio com inations, the option of merging CPC and #orely is the most affecti&e. 5ince in the times of recession the mutual usiness doesn2t lose money and in times of economic oom it pro&ides reasona le returns on the in&estments. *he com ination of CPC and #orely doesn2t pro&ide the same le&el of expected return that CPC and +,* pro&ides, howe&er it is the est option from the di&ersification stand point.

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)i liography +hrhardt, +. F. %788/'. :inancial !anagementB Theory and ractice 1)e. #asonD Cengage >earning.

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