...Required Rate of Return on stocks Name: Course: Instructor: Date: REQUIRED RATE OF RETURN ON STOCKS Introduction The full amount of risks that any investment faces is composed of the summation of the diversifiable and the non-diversifiable risks. As shown in the formula below. Total Risk = Systematic (non-diversifiable) Risk + Diversifiable Risks The Systematic risk is defined as the effect of risk that every type of investment will come across owing to the geo-political factors such as inflation. The unsystematic risk is attributed to factors such as poor leadership, labor factors among others. Unlike the systematic risk, it can be lowered by spreading the investment portfolio to different firms in diverse sectors or by investing in the different classes of assets. Total Risk = Systematic Risk + Diversifiable Risks Required Return = Risk-Free Rate + Risk Premium = Risk-Free Rate + [Beta × (Market Return – Risk-Free Rate)] Beta (Year = 2008) MNQ Company's common stock 0.85 Stock #1 1.5 Stock #2 0.27 Stock #3 1.1 Stock #4 2.15 Stock #5 -0.5 Stock #6 0.7 Stock #7 1.4 Stock #8 1.2 Stock #9 0.65 Risk-Free Rate of Return = 5% Market Risk Premium = 6% Required rate of return MNQ Company's common stock 5% + [0.85 × (6% - 5%)] = 5.85% Stock #1 ...
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...CHAPTER 2 RISK AND RETURN: PART I (Difficulty: E = Easy, M = Medium, and T = Tough) True-False Easy: (2.2) Payoff matrix Answer: a Diff: E [i]. If we develop a weighted average of the possible return outcomes, multiplying each outcome or "state" by its respective probability of occurrence for a particular stock, we can construct a payoff matrix of expected returns. a. True b. False (2.2) Standard deviation Answer: a Diff: E [ii]. The tighter the probability distribution of expected future returns, the smaller the risk of a given investment as measured by the standard deviation. a. True b. False (2.2) Coefficient of variation Answer: a Diff: E [iii]. The coefficient of variation, calculated as the standard deviation divided by the expected return, is a standardized measure of the risk per unit of expected return. a. True b. False (2.2) Risk comparisons Answer: a Diff: E [iv]. The coefficient of variation is a better measure of risk than the standard deviation if the expected returns of the securities being compared differ significantly. a. True b. False (2.3) Risk and expected return Answer: a Diff: E [v]. Companies should deliberately increase their risk relative to the market only if the actions that increase the risk also increase the expected rate of return on the firm's assets by enough to completely compensate for the higher risk. a. True b. False (2.2) Risk...
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...If the risk-free rate rises by 0.5% but the market risk premium declines by that same amount, then the required rates of return on stocks with betas less than 1.0 will decline while returns on stocks with betas above 1.0 will increase. Correct Answer: If the risk-free rate rises by 0.5% but the market risk premium declines by that same amount, then the required rate of return on an average stock will remain unchanged, but required returns on stocks with betas less than 1.0 will rise. . Question 2 .0 out of 4 points Incorrect Assume that the risk-free rate is 6% and the market risk premium is 5%. Given this information, which of the following statements is CORRECT? Answer Selected Answer: An index fund with beta = 1.0 should have a required return less than 11%. Correct Answer: An index fund with beta = 1.0 should have a required return of 11%. . Question 3 .4 out of 4 points Correct Which of the following statements is CORRECT? (Assume that the risk-free rate is a constant.) Answer Selected Answer: If the market risk premium increases by 1%, then the required return will increase by 1% for a stock that has a beta of 1.0. Correct Answer: If the market risk premium increases by 1%, then the required return will increase by 1% for a stock that has a beta of 1.0. . Question 4 .4 out of 4 points Correct How would the Security Market Line be affected, other things held constant, if the expected inflation rate decreases and investors...
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...The return from holding an investment over some period of time is simply any cash payments received due to ownership, plus the change in market price usually expressed as a percent of the beginning market price of the investment. Return comes to you mainly from two sources – income or dividend plus any price appreciation (capital gain or loss) Dt + ( Pt – Pt-1) R = Pt-1 Suppose, you buy for Tk. 100 a security that would pay Tk. 7 in cash to you and be worth Tk. 106 one year later. This return would be (7 +6)/ 100 = 13%. Risk can be defined as the variability of return from those that are expected. In financial decisions it is often helpful to have an objective measure of risk. The main reason for having measuring of risk is to enable us to make better decisions. To be useful, a risk measure should enable us to rank alternative risky ventures. If there are two possibilities being analyzed, A and B, it is often important to know whether A is riskier than B or not. A good measure of risk should also tell us how much more risky A is than B. Is A twice as risky or ten times as risky as B? Is risky at all? Risk measurement procedures are usually based on a particular method of organizing financial problem -through probability distribution. (A set of possible values that a random variable can assume and their associated probabilities of occurrence.) Suppose you are thinking about purchasing stock A, which has a current...
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...CHAPTER 7 STOCKS AND THEIR VALUATION (Difficulty: E = Easy, M = Medium, and T = Tough) Multiple Choice: Conceptual Easy: Required return Answer: d Diff: E [i]. If the expected rate of return on a stock exceeds the required rate, a. The stock is experiencing supernormal growth. b. The stock should be sold. c. The company is probably not trying to maximize price per share. d. The stock is a good buy. e. Dividends are not being declared. Constant growth model Answer: a Diff: E [ii]. Which of the following statements is most correct? a. The constant growth model takes into consideration the capital gains earned on a stock. b. It is appropriate to use the constant growth model to estimate stock value even if the growth rate never becomes constant. c. Two firms with the same dividend and growth rate must also have the same stock price. d. Statements a and c are correct. e. All of the statements above are correct. Constant growth model Answer: a Diff: E [iii]. Which of the following statements is most correct. a. The stock valuation model, P0 = D1/(rs - g), can be used for firms which have negative growth rates. b. If a stock has a required rate of return rs = 12 percent, and its dividend grows at a constant rate of 5 percent, this implies that the stock’s dividend yield is 5 percent. c. The price of a stock is the present value of all expected future...
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...of directors usually once a year to elect with vote taken at an annual meeting. Each share of stock has one vote. Stockholders can show up to the meeting and vote in person, but they can transfer their right to vote to a proxy. Common Stockholders have the preemptive right to purchase any additional shares sold by the firm It enables current stockholders to maintain control and prevents a transfer of wealth from current stockholders to new stockholders. b. Valuation of Stocks (1) Write out a formula that can be used to value any stock, regardless of its dividend pattern. Value of stock = P0 = PV of expected future dividends P0= D1(1+rs)1 + D2(1+rs)2+ … + D∞(1+rs)1∞ (2) What is a constant growth stock? How are constant growth stocks valued? A constant growth stock is one in which the stream of dividends is expected to grow at a constant rate. A constant growth stock can be valued using the constant growth model (Gordon model) shown below. P0= D1rs-g (3) What happens if a company has a constant g that exceeds its rs? Will many stocks have expected g> rs in the short run (i.e., for the next few years)? In the long run (i.e., forever)? If a company’s g is greater than their expected rs the constant growth model cannot be used. The result would be a stock price which is infinite, which can never be true. For companies such as these, the normal Stock valuation formula can be used instead. P0= D1(1+rs)1 + D2(1+rs)2+ … + D∞(1+rs)1∞ Many companies...
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...CHAPTER 7 STOCKS AND THEIR VALUATION (Difficulty: E = Easy, M = Medium, and T = Tough) Multiple Choice: Conceptual Easy: Required return Answer: d Diff: E [i]. If the expected rate of return on a stock exceeds the required rate, a. The stock is experiencing supernormal growth. b. The stock should be sold. c. The company is probably not trying to maximize price per share. d. The stock is a good buy. e. Dividends are not being declared. Constant growth model Answer: a Diff: E [ii]. Which of the following statements is most correct? a. The constant growth model takes into consideration the capital gains earned on a stock. b. It is appropriate to use the constant growth model to estimate stock value even if the growth rate never becomes constant. c. Two firms with the same dividend and growth rate must also have the same stock price. d. Statements a and c are correct. e. All of the statements above are correct. Constant growth model Answer: a Diff: E [iii]. Which of the following statements is most correct. a. The stock valuation model, P0 = D1/(rs - g), can be used for firms which have negative growth rates. b. If a stock has a required rate of return rs = 12 percent, and its dividend grows at a constant rate of 5 percent, this implies that the stock’s dividend yield is 5 percent. c. The price of a stock is the present value of all expected future...
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...CHAPTER 7 STOCKS AND THEIR VALUATION (Difficulty: E = Easy, M = Medium, and T = Tough) Multiple Choice: Conceptual Easy: Required return Answer: d Diff: E [i]. If the expected rate of return on a stock exceeds the required rate, a. The stock is experiencing supernormal growth. b. The stock should be sold. c. The company is probably not trying to maximize price per share. d. The stock is a good buy. e. Dividends are not being declared. Constant growth model Answer: a Diff: E [ii]. Which of the following statements is most correct? a. The constant growth model takes into consideration the capital gains earned on a stock. b. It is appropriate to use the constant growth model to estimate stock value even if the growth rate never becomes constant. c. Two firms with the same dividend and growth rate must also have the same stock price. d. Statements a and c are correct. e. All of the statements above are correct. Constant growth model Answer: a Diff: E [iii]. Which of the following statements is most correct. a. The stock valuation model, P0 = D1/(rs - g), can be used for firms which have negative growth rates. b. If a stock has a required rate of return rs = 12 percent, and its dividend grows at a constant rate of 5 percent, this implies that the stock’s dividend yield is 5 percent. c. The price of a stock is the present value of all expected future...
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...the volatility of a stock as compared to the market our estimated beta for Oracle will be 1.5. If both stock and market move in the same direction with same volatility the beat is 1. In this case we have added the difference (0.40 + 0.10) to 1 and have estimated the number (Beta) at 1.50. Ki = RF + bi (KM - RF ) Where KF (Risk free rate ) = 4.6% (KM – K F) Equity risk premium = 6.4% Bi (Beta) = 1.5 Ki (Required rate of Return) = 4.6% + (1.5 x 6.4) = 4.6% + 9.6% = 14.2% Answer no 9 (a) : McDonalds (MCD): On the basis as described above the beta for MCD is 1.55. So the required rate of return will be as follows: Ki = RF + bi (KM - RF ) Where KF (Risk free rate ) = 4.6% (KM – K F) Equity risk premium = 6.4% Bi (Beta) = 1.55 Ki (Required rate of Return) = 4.6% + (1.55 x 6.4) = 4.6% + 9.92% = 14.52% Answer no 9 (b) : Bank of America: (BAC): On the basis as described above the beta for BAC is 0.50. So the required rate of return will be as follows: Ki = RF + bi (KM - RF ) Where KF (Risk free rate ) = 4.6% (KM – K F) Equity risk premium = 6.4% Bi (Beta) = 0.50 Ki (Required rate of Return) = 4.6% + (0.50 x...
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...Merrill Finch Inc. Risk and Return Assume that you recently graduated with a major in finance. You just landed a job as a financial planner with Merrill Finch Inc., a large financial services corporation. Your first assignment is to invest $100,000 for a client. Because the funds are to be invested in a business at the end of 1 year, you have been instructed to plan for a 1-year holding pe riod. Further, your boss has restricted you to the investment alternatives in the following table, shown with their probabilities and associated outcomes. (For now, disregard the items at the bottom of the data; you will fill in the blanks later.) Returns on Alternative Investments Estimated Rate of Return State of the Economy Prob. T-Bills High Tech Collec- tions U.S. Rubber Market Portfolio 2-Stock Portfolio Recession 0.1 5.5% -27.0% 27.0% 6.0% a -17.0% 0.0% Below Avg. 0.2 5.5 -7.0 13.0 -14.0 -3.0 Average 0.4 5.5 15.0 0.0 3.0 10.0 7.5 Above Avg. 0.2 5.5 30.0 -11.0 41.0 25.0 Boom 0.1 5.5 45.0 -21.0 26.0 38.0 12.0 r-hat ( r ˆ ) 1.0% 9.8% 10.5% Std. dev. ( ) 0.0 13.2 18.8 15.2 3.4 Coeff. of Var. (CV) 13.2 1.9 1.4 0.5 beta (b) -0.87 0.88 a Note that the estimated returns of U.S. Rubber do not always move in the same direction as the overall economy. For example, when the economy is below average, consumers purchase fewer tires than they would if the economy were stronger. However, if the economy is in a flat-out recession, a large number...
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...Risk and Rates of Return Risk – The chance that some unfavorable event will occur; investment risk can be measured by the variability of the investment’s return. Stand-Alone Risk • Probability Distributions Subjective (estimated) Objective (historical) Continuous Discrete • Expected Rate of Return … weighted average of all possible outcomes … the rate of return expected to be realized from an investment … the mean value of the probability distribution of possible results • Variance ((2) • Standard Deviation (() … measures total risk • Coefficient of Variation (CV = (/k) … measures risk per unit of return … can be used to rank stocks based upon their risk/return characteristics … the CV is most useful when analyzing investments that have different expected rates of return and different levels of risk • Risk Aversion … the greater a security’s risk, the greater the return investors will demand and thus the less they are willing to pay for the investment • Risk Premium …the portion of a security’s expected return that is attributed to the additional risk of an investment over and above the “risk-free” rate of return Portfolio Risk • Portfolio – a collection or grouping of investment securities or assets • Efficient Portfolio 1) Maximize return for a given level of risk 2) Minimize risk for a given level...
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...or From Our Search Bar (http://hwguiders.com/ ) FIN 571 W2 Ch 5 Problem A1 (Bond Valuation) FIN 571 W2 Ch 5 Problem A10 (Dividend discount model) FIN 571 W2 Ch 5 Problem A12 (Required return for a preferred stock) FIN 571 W2 Ch 5 Problem A14 (Stock Valuation) FIN 571 W2 Ch 5 Problem B16 (Interest-rate risk) FIN 571 W2 Ch 5 Problem B18 (Default risk) FIN 571 W2 Ch 5 Problem B20 (Constant growth model) FIN 571 W2 Ch 7 Problem C1 (Beta and required return) FIN 571 Week 2 Individual Assignment Text Problem Sets Get Tutorial by Clicking on the link below or Copy Paste Link in Your Browser https://hwguiders.com/downloads/fin-571-week-2-individual-assignment-text-problem-sets/ For More Courses and Exams use this form ( http://hwguiders.com/contact-us/ ) Feel Free to Search your Class through Our Product Categories or From Our Search Bar (http://hwguiders.com/ ) FIN 571 W2 Ch 5 Problem A1 (Bond Valuation) FIN 571 W2 Ch 5 Problem A10 (Dividend discount model) FIN 571 W2 Ch 5 Problem A12 (Required return for a preferred stock) FIN 571 W2 Ch 5 Problem A14 (Stock Valuation) FIN 571 W2 Ch 5 Problem B16 (Interest-rate risk) FIN 571 W2 Ch 5 Problem B18 (Default risk) FIN 571 W2 Ch 5 Problem B20 (Constant growth model) FIN 571 W2 Ch 7 Problem C1 (Beta and required return) FIN 571 Week 2 Individual Assignment Text Problem Sets Get Tutorial by Clicking on the link below or Copy Paste Link in Your Browser...
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...Question 1 2 out of 2 points | | | Your bank account pays an 8% nominal rate of interest. The interest is compounded quarterly. Which of the following statements is CORRECT? | | | | | Selected Answer: | The periodic rate of interest is 2% and the effective rate of interest is greater than 8%. | Correct Answer: | The periodic rate of interest is 2% and the effective rate of interest is greater than 8%. | | | | | * Question 2 2 out of 2 points | | | Which of the following statements is CORRECT? | | | | | Selected Answer: | The cash flows for an annuity due must all occur at the beginning of the periods. | Correct Answer: | The cash flows for an annuity due must all occur at the beginning of the periods. | | | | | * Question 3 2 out of 2 points | | | Your bank offers a 10-year certificate of deposit (CD) that pays 6.5% interest, compounded annually. If you invest $2,000 in the CD, how much will you have when it matures? | | | | | Selected Answer: | $3,754.27 | Correct Answer: | $3,754.27 | | | | | * Question 4 0 out of 2 points | | | Which of the following statements is CORRECT? | | | | | Selected Answer: | The present value of a 3-year, $150 ordinary annuity will exceed the present value of a 3-year, $150 annuity due. | Correct Answer: | If a loan has a nominal annual rate of 7%, then the effective rate...
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... Barney Smith's economic forecasting staff has developed estimates for the state of the economy and its security analyst have developed a sophisticated computer program which was used to estimate the rate of return on each state of the economy. Alta Industries, Inc. is an electronics firm; Repo Men Inc. collects past due debts; and American Foam manufactures mattresses and various other foam products. Merril Finch also maintains an "index fund" which owns a market-weighted fraction of all publicly traded stocks; you can invest in that fund, and thus obtain average stock market results. Given the situation as described, answer the following questions. State of Economy Probability T-Bills Alta Inds. Repo Men American Foam Market Port. 2-Stock Portfolio Recession 0.1 8.00% -22.00% 28.00% 10.00% -13.00% 3.00% Below Average 0.2 8.00% -2.00% 14.70% -10.00% 1.00% Average 0.4 8.00% 20.00% 0.00% 7.00% 15.00% 10.00% Above Average 0.2 8.00% 35.00% -10.00% 45.00% 29.00% Boom 0.1 8.00% 50.00% -20.00% 30.00% 43.00% 15.00% Return on Investment...
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...years and a required return of 9%. The bond’s coupon rate is 7.4%. What is the fair value of this bond? Calculating PV factor: i= required return = 9% = 0.09 n= 10 years Using Cash Flow of $1000 to calculate present value, Cash flow= $1000 PV factor = 1/(1+i)^n = 0.42241 PV = $1000*0.42241= 422.41 Using Coupon Rate to calculate present value of Annuity Cash flow= $1000 * 7.4/100 = $74 PV factor = (1/i)*(1- 1/(1+i)^n) = 6.4176 So, PV = $74*6.4176 = 474.90| So the fair value of bond = 474.90+422.41 = $897.31 A10. (Dividend discount model) Assume RHM is expected to pay a total cash dividend of $5.60 next year and its dividends are expected to grow at a rate of 6% per year forever. Assuming annual dividend payments, what is the current market value of a share of RHM stock if the required return on RHM common stock is 10%? Current market value = D1/(Required return – growth rate) = 5.60/(10%-6%) = $140 A12. (Required return for a preferred stock) James River $3.38 preferred is selling for $45.25. The preferred dividends is now growing. What is the required return on James River preferred stock? Required Return = Dividend/Market Price Dividend = $3.38 Market Price = $45.25 Required Return = $3.38 / $45.25 Required Return = 7.47% A14.(Stock Valuation) Suppose Toyota has nonmaturing (perpetual) preferred stock outstanding that...
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