Chapter 9

202

CHAPTER 9: RISK AND RETURN

1. The Duncan Company's stock is currently selling for $15. People generally expect its price to rise to
$18 by the end of next year. They also expect that it will pay a dividend of $.50 per share during the
year. (Hint: Apply Equation 9.2 page 406.)
a. What is the expected return on an investment in Duncan's stock?
b. Recalculate the expected return if next year's price is forecast to be only $17 and the dividend $.25.
c. Calculate the actual return on Duncan if at the end of the year the price turns out to be $13 and the
dividend actually paid was just $.10.
SOLUTION:
D (P P )
1
1
0
P
0
$.50 ($18 $15)
k
23.3%
e
$15
k

a.

b.
ke

$.25 ($17 $15)

15.0%
$15

ka

$.10 ($13 $15)

12.7%
$15

c.

2.
The Rapscallion Companys stock is selling for $43.75. Dave Jones has done some research on
the firm and its industry, and thinks it will pay dividends of $5 next year and $7 the following year.
After those two years Dave thinks its market price will peak at $50. His strategy is to buy now, hold for
the two years and then sell at the peak price. If Dave is confident about his financial projections but
requires a return of 25% before investing in stocks like Rapscallion, should he invest in this
opportunity? (Hint: The return on a multi-ear investment is the discount (interest) rate that makes the
present value of the future cash flows equal to the price. See pages 299-300 at the beginning of Chapter
7.)
SOLUTION:
To solve this problem we must find the return on Daves prospective investment and see if it
exceeds 25%. We do that by calculating the present value of the investments cash flows at various
interest rates until we find one that yields $43.75. The cash flows are $5 in year 1 and a total of $57
($50 + $7) in year 2.
A discount rate of 20% gives the following.
P0 = $5[PVF20,1] + $57[PVF20,2]
= $5(.8333) + $57(.6944)
= $4.17 + $39.58
= $43.75
Hence, Dave should not invest because the expected 20% return does not exceed his required
return of 25%.
NOTE: Problems 5-8 assume discrete probability distributions for the returns on stocks to keep
the computations simple.

203

Chapter 9

Evaluating Stand-Alone Risk: Example 9-4, (page 417)

5.
Conestoga Ltd. has the following estimated probability distribution of returns.
Return
Probability
4%
.20
12%
.50
14%
.30
Calculate Conestogas expected return, the variance and standard deviation of its expected return and
the returns coefficient of variation.
SOLUTION:
First calculate the mean or expected value, k.
Return Probability
Product
k
P(k) kP(k)
4%
.20
.8%
12%
.50
6.0%
14%
.30
4.2%
Expected Value = k =
11.0%
Variance and Standard Deviation

(k k )

4%
12%
14%

-7
1
3

(k k ) 2
(k k ) 2 P( k )
49
9.8
1
0.5
9
2.7
Variance = 2 = 13.0
Standard Deviation = = 3.6

Coefficient of Variation
CV = Std Dev / Mean = 3.6/11.0 = .33
7.
Calculate the expected return on an investment in Delta Inc.'s stock if the probability
distribution of returns is as follows.
Return Probability
-5%
.10
5%
.25
10%
.30
15%
.25
25%
.10
Plot the distribution on the axis with Omega Inc. of the previous problem. Based on the graph,
which company has the lower risk/variance? If offered the choice between making an investment in
Delta and in Omega Inc., which would most investors choose? Why?
SOLUTION:
Expected Return:
Return
-5%
5%
10%
15%

Prob =
.10
.25
.30
.25

Factor
-0.50%
1.25%
3.00%
3.75%

Risk and Return

25%

204

.10
2.50%
Expected return = k = 10.00%

Most investors would choose Omega, because it has a lower risk/variance coupled with the same
expected return as Delta.
8.
The Manning Company's stock is currently selling for $23. It has the following prospects for
next year:
Next year's
Stock Price
Dividend
Probability
$25
$1.00
.25
$30
$1.50
.50
$35
$2.00
.25
Calculate Manning's expected return for a one-year holding period.
SOLUTION:
k
k

$1 ($25 $23)

$23

$1.50 ($30 $23)

37.0%
$23

13.0%

P(k)

kP(k)

.25

3.25%

.50

18.50%

$2 ($35 $ 3)2
60.9% .25 15.23%
$23
_

k 36.98%

Portfolio Return: Example 9-5, (page 421)

10.
A portfolio consists of the following four stocks.
Current
Expected
Market Value
Return
$180,000
8%
$145,000
10%
$452,000
12%
$223,000
5%
$1,000,000
What is the expected return of the portfolio?
Stock
A
B
C
D

SOLUTION:
Stock
A
B
C
D

Current
Market Value Weight
$180,000
18.0%
$145,000
14.5%
$452,000
45.2%
$223,000
22.3%
$1,000,000
100.0%

Expected
Return = Factor
8%
1.44%
10% 1.45
12% 5.42
5%
1.12
9.43%
use:
9.4%

205

11.

Chapter 9

Laurel Wilson has a portfolio of five stocks. The stocks actual investment performance last
year is given below along with an estimate of this years performance.
Last Year
This Year
Stock
Investment
Return
Investment
Return
A
$50,000
8.0%
$55,000
8.5%
B
$40,000
6.0%
$40,000
7.0%
C
$80,000
4.0%
$60,000
4.5%
D
$20,000
12.0%
$45,000
9.0%
E
$60,000
3.0%
$50,000
5.0%
Compute the actual return on Laurels overall portfolio last year and its expected return this
year.

SOLUTION:
Last year the total portfolio was $250,000
Stock A50/250 * 8% = 1.60%
Stock B40/250 * 6% = 0.96%
Stock C80/250 * 4% = 1.28%
Stock D20/250 * 12% = 0.96%
Stock E 60/250 * 3% = 0.72%
5.52% total return
This year the total portfolio was $250,000
Stock A55/250 * 8.5% = 1.87%
Stock B40/250 * 7.0% = 1.12%
Stock C60/250 * 4.5% = 1.08%
Stock D45/250 * 9.0% = 1.62%
Stock E 50/250 * 5.0% = 1.00%
6.69% total return
Projecting Returns with Beta: Example 9-6 (page 428)
12. Threads Inc. manufactures stylish clothing for teenagers. The firm has a beta of 1.4 and earned a
return on equity of 20% last year. However, a new financial crisis has just hit the stock market and Wall
Street experts think the return on an average stock will be cut in half this year. The market has been
producing equity returns of about 18% lately. Estimate this years return on an equity investment in
Threads.
SOLUTION:
Beta represents the past average change in Threads return relative to changes in the markets return.
kThreads
bThreads =
kM
The markets return is expected to drop from 18% to half of that value or by 9%, over the
current year, and bThreads is 1.4.
Substituting,
kThreads
1.4 =
9%
From which
kThreads = 12.6%
The new equity return on Threads can be estimated as

Risk and Return

206

kThreads this yr = kThreads last yr - kThreads = 20% - 12.6% = 7.4%

Portfolio Beta: Example 9-9 (page 431)
13.
The stocks in the previous problem have the following betas.
Stock Beta
A
1.1
B
0.6
C
1.0
D
1.6
E
0.8
Calculate Laurels portfolio beta for last year and for this year. Assume that the changes in
investment (value) come from changing stock prices rather than buying and selling shares.
What has happened to the riskiness of Laurels portfolio? Should she be concerned?
SOLUTION:
Last year
Stock A50/250 * 1.1 = .220
Stock B40/250 * 0.6 = .096
Stock C80/250 * 1.0 = .320
Stock D20/250 * 1.6 = .128
Stock E 60/250 * 0.8 = .192
.956 portfolio beta
This year
Stock A55/250 * 1.1 = .242
Stock B40/250 * 0.6 = .096
Stock C60/250 * 1.0 = .240
Stock D45/250 * 1.6 = .288
Stock E 50/250 * 0.8 = .160
1.026 portfolio beta
Overall, the portfolio has become slightly more risky as a result of the change in weights in the
various stocks. However, the change in the risk profile is relatively small, so Laurel probably
shouldnt be concerned.
14.

A four-stock portfolio is made up as follows

Current
Stock
Value
Beta
A
$4,500
.8
B
2,900
.6
C
6,800
1.3
D
1,200
1.8
Calculate the portfolio's beta.
SOLUTION:
Stock
A
B
C
D

Market Value Weight

$4,500
29.2%
$2,900
18.8%
$6,800
44.2%
$1,200
7.8%
$15,400
100.0%

Beta
.8
.6
1.3
1.8

Factor
.234
.113
.575
.140
bP = 1.062

207

Chapter 9
use:

16.

1.1

The return on Holland-Wilson Inc. (HWI) stock over the last three years is shown below along
with the markets return for the same period.
Year
HWI
Market
1
4.0%
3.0%
2
9.0%
6.0%
3
12.0%
10.0%
Plot HWIs return against that of the market in each of the three years. Make three estimates of
HWIs beta by drawing characteristic lines between pairs of data points (1 and 2; 1 and 3; 2 and
3). What does this range of betas imply about the stocks risk relative to an average stock?

SOLUTION:
Using 20x1 and 20x2 data, the slope would be 4/3 or 1.33
Using 20x1 and 20x3 data, the slope would be 8/7 or 1.14
Using 20x2 and 20x3 data, the slope would be 4/4 or 1.00
The range is 1.00 to 1.33 so the actual beta is probably greater than 1.00. This would make
HWI stock slightly more risky than the average stock.
17.
You have recently purchased stock in Topical Inc. which has returned between 7% and 9% over
the last three years. Your friend, Bob, has criticized your purchase and insists that you should have
invested in Combs Inc., as he did, because its been returning between 10% and 12% in the last three
years. Bob knows nothing about financial theory. Topicals beta is 0.7 and Combs is 1.2. Treasury
bills are currently yielding the risk free rate of 4.2%, while the stock market is returning an average rate
of 9.4%.
a.
What return should you expect from Topical? What return should Bob expect from Combs?
b.
Write a few words explaining to Bob why these expected returns arent the whole story.
SOLUTION
a.
kT = kRF + (kM-kRF)bT
= 4.2 + (9.4 - 4.2).7
= 4.2 + 3.64
= 7.84%
kC = kRF + (kM-kRF)bC
= 4.2 + (9.4 - 4.2)1.2
= 4.2. + 6.24
= 10.44%
b. Bob, expected return isnt everything in an investment, risk also has to be considered. Based on past
movements in their returns, Topical is a relatively low risk stock while Combs is fairly risky. You
might make a lot on Combs, but theres a good chance youll lose money too. Topical tends to be much
more stable, and while I may not make as much if conditions are good, Im far less likely to lose
anything if conditions are bad in the coming years.
18.
Erin Behlen has a three stock portfolio and is interested in estimating its overall return next
year. She has $25,000 invested in Forms Corp., which has a beta of 1.3; $75,000 in Crete Corp. with a
beta of .8 and $20,000 in Stalls Corp, which has a beta of 1.45. The stock market is currently returning

Risk and Return

208

10.2% and Treasury securities are yielding the risk free rate of 4.6%. What return should Erin anticipate
on her portfolio?
SOLUTION
First calculate Erins portfolios beta which is the investment dollar weighted average of the betas of the
stocks it contains. First calculate the total dollar investment.
Portfolio Dollar Value = $25,000 + $75,000 + $20,000 = $120,000
Then the weighted average beta is
bP = ($25,000/120,000)1.3 + ($75,000/$120,000).8 + $20,000/$120,000)1.45 =
= .27 +.5 +.24
=1.01
Next use the SML to estimate the portfolios required return.
kP = kRF + (kM kRF)bP
= 4.6 + (10.2 4.6)1.01 = 10.26%
which is just above the markets current return.
19.
The CFO of Ramekin Pottery Inc. is concerned about holding up the price of the companys
stock. Hes asked you to do an analysis starting with an estimate of the return investors are likely to
require before they will invest in the firm. The overall stock market is currently returning 16%, 90 day
treasury bills yield 6%, and the return on Ramekins stock typically responds to changes in the political
and economic environment only about 60% as vigorously as does that of the average stock.
a. Prepare an estimate of the firms required return using the CAPM.
b. Is a higher or lower required return good for the company? Why?
c. Suppose the CFO asks you what management can do to improve the required return. How will you
respond?
d. What will you tell him if he wants it done in within the next three months?
SOLUTION:
a. Estimate the required return using the SML of the CAPM
kR = kRF + (kM kRF)bR
= 6 + (16 6).60
=6+6
= 12%
b. A lower required return is better because it is more likely to be exceeded by investors expected
returns, which implies more people interested in the stock which will tend to bid up its price. Since a
high stock price achieves managements goal of maximizing shareholder wealth, a lower required return
is desirable.
c. In terms of the SML, the only thing management can do is take actions that will lower beta, since
thats the only element of the equation thats at all controllable by the firm. This implies stabilizing the
business so that returns are less variable. The best way for management to do that is probably by
attempting to stabilize earnings from year to year. That might be difficult in this case because the firms
beta is already quite low.
d. Influencing beta in so short a time is probably impossible. Beta is derived by developing a
relationship between a stocks return and the market return over many years. That isnt likely to be
changeable to any appreciable extent in three months.
20.
You are a junior treasury analyst at the Palantine Corporation. The treasurer believes the CAPM
gives a good estimate of the company's return to equity investors at any time, and has asked you to

209

Chapter 9

prepare an estimate of that return using the SML. Treasury bills currently yield 6%, but may go up or
down by 1%. The S&P 500 shows a return of 10% but may vary from that figure up to 12%.
Palantine's beta is .8. Construct a table showing all possible values of k Palantine for 1% increments of kRF
and kM (nine lines). For this problem treat kM and kRF separately. That is, do not assume a change in kM
when kRF changes.
SOLUTION:
kRF
5%
6%
7%

kC = kRF + (kM kRF) bC

kM
10%
11%
9.0%
9.8%
9.2%
10.0%
9.4%
10.2%

12%
10.6%
10.8%
11.0%

Valuing (Pricing) a Stock with CAPM: Example 9-10 (page 437)

21.
The Framingham Company expects to grow at 4% indefinitely. Economists are currently
asserting that investment opportunities in short term government securities (treasury bills) are readily
available at a risk free rate of 5%. The stock market is returning an average rate of 9%. Framinghams
beta has recently been calculated at 1.4. The firm recently paid an annual dividend of $1.68 per share.
At what price should shares of Framingham stock be selling?
SOLUTION:
First calculate a required return for investment in Framingham stock using the SML.
kF = kRF + (kM kRF) bF
= 5 + (9 5) 1.4
= 5 + 5.6
= 10.6%
Then determine a price using the Gordon Model
D0(1+g)
(1.68) (1.04)
1.747
P0 = = = = $26.47
kF g
.106 - .04
.066
22.
Whole Foods Inc. paid a quarterly dividend of $0.47 recently. Treasury bills are yielding 4%,
and the average stock is returning about 11%. Whole Foods is a stable company. The return on its stock
responds to changes in the political and economic environment only about 70% as vigorously as that of
the average stock. Analysts expect the firm to grow at an annual rate of 3.5% into the indefinite future.
Calculate a reasonable price that investors should be willing to pay for Whole Foods stock.

SOLUTION:
Calculate a required return for Whole Foods using the SML.
kWF = kRF + (kM kRF) bWF

Risk and Return

210

= 4 + (11 4) .7
= 4 + 4.9
= 8.9%
Determine a price using the Gordon Model first noticing that the annual dividend rate is the recent
quarterly payment times 4. Hence:
D0 = $0.47 x 4 = $1.88
and
D0(1+g)
(1.88) (1.035) 1.946
P0 = = = = $39.71
kg
.089 - .04
.049
23.
Seattle Software Inc. recently paid an annual dividend of $1.95 per share and is expected to
grow at a 15% rate indefinitely. Short term federal government securities are paying 4% while an
average stock is earning its owner 11%. Seattle is a very volatile stock, responding to the economic
climate two and a half times violently as an average stock. This is, however, typical of the software
industry.
a. How much should a share of Seattle be worth?
b. Do you see any problems with this estimate? Change one assumption to something more reasonable
and compare the results.
SOLUTION:
a. First solve the SML for Seattles required return.
KS = kRF + (kM kRF)bS
= 4 + (11 4)2.5
= 4 + 17.5
= 21.5%
Then substitute into the Gordon Model.
P0 = D0(1 + g) / (k g)
= $1.95(1.15) / (.215 - .15)
= $2.24 / .065
= $34.46
b. The growth assumption is probably too aggressive even for the software industry. Growth of 15%
forever is unlikely. Recalculate the second step of the estimating process with an 8% growth
assumption.
P0 = D0(1 + g) / (k g)
= $1.95(1.08) / (.215 - .08)
= $2.11 / .135
= $15.63
24.
The Aldridge Co. is expected to grow at 6% into the indefinite future. Its latest annual dividend
was $2.50. Treasury bills currently earn 7% and the S&P 500 yields 11%.
a. What price should Aldridge shares command in the market if its beta is 1.3?

211

Chapter 9

b. Evaluate the sensitivity of Aldridge's price to changes in expected growth and risk by recalculating
the price while varying the growth rate between 5% and 7% (increments of 1%) and varying beta
between 1.2 and 1.4 (increments of .1).
SOLUTION:
a.

kA = kRF + (kM kRF) bA

= 7% + (11% 7%) 1.3
= 12.2%
P0

D 0 (1 g )
kg

$2.50(1.06)
$42.74
.122 .06

b.
bA
1.2
1.3
1.4

5%
$38.60
$36.53
$34.61

g
6%
$45.69
$42.74
$40.15

7%
$55.83
$51.54
$47.86

25.
Bergman Corp. has experienced zero growth over the last seven years paying an annual
dividend of $2.00 per share. Investors generally expect this performance to continue. Bergman stock is
currently selling for $24.39. The risk-free rate is 3.0% and Bergmans beta is 1.3.
a.
b.
c.

Calculate the return investors require on Bergmans stock.

Calculate the market return.
Suppose you think Bergman is about to announce plans to grow at 3.0% into the foreseeable
future. You also believe investors will accept that prediction and continue to require the same
return on its stock. How much should you be willing to pay for a share of Bergmans stock.

SOLUTION:
a.
Use the Gordon Model with g=0 to find Bergmans required rate of return
P0 = D0(1+g) / (k-g) = D0 / k
$24.39 = $2.00 / k
k = .082
or 8.2%
b.
Use the SML to find the market return, kM.
kX = kRF + (kM-kRF)bX
8.2 = 3.0 + (kM-3.0)1.3
from which
kM = 7.0%
c.
P0 = D0(1+g) / (k-g)
= [$2.00 (1.03)]/(.082 - .03)
= $39.62
26.
Weisman Electronics just paid a $1.00 dividend, the market yield is yielding 10%, the risk-free
rate is 4%, and Weismans beta is 1.5. How fast do investors expect the company to grow in the future
if its stock is selling for $27.25.
SOLUTION:
First solve for Weismans required return using the SML
kX = kRF + (kM-kRF)bX

Risk and Return

212

= 4 + (10 4)1.5
= 13%
The solve for Weismans growth rate using the Gordon Model;
P0 = D0(1+g) / (k-g)
$27.25 = [$1.00 (1+g)]/(.13 g)
from which
g = .09 or 9%
Strategic Decisions Based on CAPM: Example 9-11 (page 438)
27.
Weisman Electronics of the previous problem is considering acquiring an unrelated business.
Management thinks the move could change the firms stock price by moving its beta up or down and
decreasing its growth rate. A consultant has estimated that Weismans beta after the acquisition could
be anywhere between 1.3 and 1.7 while the growth rate could remain at 4% or decline to as little as 3%.
Calculate a range of intrinsic values for Weismans stock based on best and worst-case scenarios. (Hint:
Consider combinations of the highest and lowest beta and growth rate, but dont make four sets of
calculations. Think through which way a change in each variable moves stock price and evaluate only
two scenarios.)
SOLUTION:
Worst case: 8% growth rate and 1.7 beta
Required return = 4 + 6 (1.7) = 14.2%
Stock price = $1.08/(.142 - .08) = $17.42
Best case: 9% growth rate and 1.3 beta
Required return = 4 + 6 (1.3) = 11.8%
Stock price = $1.09/(.118 - .09) = $38.93
28.
Broken Wing Airlines just paid a $2 dividend and has a beta of 1.3 and a growth rate of 6% for
the foreseeable future. The current return on the market is 10% and Treasury bills earn 4%. If the rate
on Treasury bills drops by 0.5% and the market risk premium [(k M - kRF)] increases by 1.0%, what
growth rate would keep Broken Wings stock price constant? (Hint: Calculate the price before rates
change, then use it as P0 in a problem with the changed rates and solve for g.)
SOLUTION:
First calculate Broken Wings required return using the SML:
4 + 6 (1.3) = 11.8%
Then calculate its intrinsic value using the Gordon Model
P0= [$2.00 (1.06)]/(.118 - .06) = $36.55
If the rate on Treasury bills drops by 0.5% and the market risk premium increases by 1.0%,
Broken Wings new require return would be:
3.5 + 7 (1.3) = 12.6%
Then solve for a growth rate that will maintain the intrinsic value of $36.55
$36.55 = [$2.00 (1 + g)]/(.126 g)
(.126 g) 36.55 = 2 + 2g
4.6053 36.55g = 2 + 2g
2.6053 = 38.55g
g = .068 or 6.8%
29.
Lipson Ltd. expects a constant growth rate of 5% in the future. Treasury bills yield 8% and the
market is returning 13% on an average issue. Lipson's last annual dividend was $1.35. The company's
beta has historically been .9. The introduction of a new line of business would increase the expected

213

Chapter 9

growth rate to 7% while increasing its risk substantially. Management estimates the firm's beta would
increase to 1.2 if the new line is undertaken. Should Lipson undertake the new line of business?
SOLUTION:
Existing stock price:
kL = kRF + (kM kRF) bL
= 8% + (13% 8%) .9
= 12.5%
P0

D 0 (1 g )
kg

$1.35(1.05)
$18.93
.125 .05

Price with the new line:

kL

P
0

= kRF + (kM kRF) bL

= 8% + (13% 8%) 1.2
= 14.0%
D (1 g )
$1.35(1.07 )
0

$20.64
kg
.14 .07

Hence the new line of business appears to have a net positive effect on stock price and should be
adopted.