FIN 612 Chapter Notes - Chapter 2: Relative Risk, Takers, The Globe And Mail

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emeraldllama178

29 Mar 2015

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When choosing or evaluating an investment for yourself or your client, you need to understand: average rates of return (k) for different kind of assets (called asset classes, standard deviation ( ) of each asset class. Average rate of return for investments are useful when choosing a realistic rate of return on. While the standard deviations don"t show much change when converted to real dollars, nominal. & real rates of return can change a great deal. An average rate of return can be calculated form a few years or many years. The user must exercise judgement as to what reasonable time period would be useful the long- bull run of the 1990s would tend to increase expectations about what constitutes a reasonably good rate of return. Only if you want to assume business conditions haven"t changed over 50 years: unfortunately, there is no correct answer & only judgement can be used to make the.

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Fill in the blank using a number of terms listed below (@1 point per question).

Beta coefficient, Bonds, CAPM, Cash flows, Change, CV, Convertible bonds, Correlation, Correlation coefficient, Debenture, Discount, Diversifiable risk, Expected return, Interest rate risk, Inverted, Junk Bonds, Market risk, More, Normal, Opposite, Probability distribution, Ratings, Reinvestment rate risk, Risk, Risk averse investor, Risk premium, Standard deviation

______________is the chance that some unfavorable event will occur. For instance, the risk of an asset is essentially the chance that the assetâs cash flows will be unfavorable or less than expected.

A __________________ is a listing, chart or graph of all possible outcomes, such as expected rates of return, with a probability assigned to each outcome.

The ______________________is a statistical measure of the variability of a set of observations. The variance of the probability distribution is the sum of the squared deviations about the expected value adjusted for deviation.

The _______________________ is equal to the standard deviation divided by the expected return; it is a standardized risk measure which allows comparisons between investments having different expected returns and standard deviations.

A _______________________ dislikes risk and requires a higher rate of return as an inducement to buy riskier securities. A realized return is the actual return an investor receives on their investment. It can be quite different than their _______________________.

A ________________ is the difference between the rate of return on a risk-free asset and the expected return on Stock i which has higher risk.

_________________ is a model based upon the proposition that any stockâs required rate ofreturn is equal to the risk free rate of return plus a risk premium reflecting onl y the risk remaining after diversification.

_________________ is the tendency of two variables to move together. A _________________ of +1.0 means that the two variables move up and down in perfect synchronization, while a coefficient of -1.0 means the variables always move in opposite directions.

_________________ is that part of a securityâs total risk that cannot be eliminated by diversification. It is measured by the beta coefficient. _________________ is also known as company specific risk. This risk can be eliminated by proper diversification.

The _________________ is a measure of a stockâs market risk, or the extent to which the returns on a given stock move with the stock market.

Assume that you have $100,000 to invest for your retirement. You wish to balance your funds between the three categories of Cash (or money market like investments), Bonds and Stocks. Based on historical data, the statistics on past performance of these investments (in real interest rates, that is discounted for inflation) are:

Cash Bonds Stocks

Average Return 3% 6% 9%

Standard Deviation 1% 2% 3%

and the correlation Cash and Bonds is +.4; the correlation between Cash and Stocks is -.5; and the correlation Bonds and Stocks is -.3.

You have consulted two investment advisors. The first recommends that you put $10,000 in Cash ad the remaining $90,000 in Bonds. The second advisor recommends that you put $55,000 in Cash and $45,000 in Stocks.

Assignment:

Verify that both of these advisors have recommended portfolios with the same yield but with different risks. (You may use the EXCEL worksheet I gave you to do this).

A classmate points out to you that this comparison is based on only a one year period and that you should be looking at the long run. Specifically she argues that since this money is for your retirement, the investments might give very different results if you invested them for 30 years. In order to determine the wisdom of her comments you decide to simulate these two investments using the techniques discussed in this class for the number of years left before your retire (assuming you retire at age 65). You decide to do this in two ways. In the first way you simply make the two investments and track the resulting cumulative yield over the course of your anticipated working years. In the second way, you adjust the amount of money yielded at the end of each year to keep the percentage of funds invested in each vehicle the same as in the first year (for example with the first investment you would each year invest 10% of the cumulative proceeds in Cash and 90% in Bonds).

Simulate the long term return on the two investments ten times each way and use the results to comment on her observation.

Hints:

You can assume that the yearly returns of the investment vehicles are normally distributed with the means, standard deviations and correlations given above.

You will have to generate separate yearly return data for each Portfolio in order to simulate the correlations correctly.

Since the only difference between the first and second ways of investing is to adjust the amounts of money yearly the second way, you can use the same sequence of simulated values for both.

After you have your ten simulations for each portfolio and each way ofadjusting, compute the average long term return and the standard deviation of the long term return.

5) Discuss the results in the light of your classmateâs comments.

6) The basic question to be answered is whether the short term results can be used to indicate what will happen in the long run.

Question 5

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.

True

False

Question 6.

In portfolio analysis, we often use ex post (historical) returns and standard deviations, despite the fact that we are interested in ex ante (future) data.

True

False

Question 7

Typically, debentures have higher interest rates than mortgage bonds primarily because the mortgage bonds are backed by assets while debentures are unsecured.

True

False

Question 8

If two firms have the same current dividend and the same expected growth rate, their stocks must sell at the same current price or else the market will not be in equilibrium.

True

False

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Question 9

Which of the following is the best measure of the wealth of a firm's stockholders?

The firm's Net Income during the past year

Expected Earnings per Share during the coming year

Book Value (or Net Worth) as recorded on the balance sheet

The price of the firm's stock on the open market

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Question 10

Consider the following firms:

	Net Income	Stock Price at	Stock Price at
	this year	Beg of Year	End of Year
Firm A:	$10,000,000	$20	$10
Firm B:	$(10,000,000)	$10	$20

The manager of Firm A is doing a better job than B

The manager of Firm B is doing a better job than A

Neither manager is doing a good job

Both managers are doing a good job

Question 11

A company has the following income statement. What is its net operating profit after taxes (NOPAT)?

Sales $1,000
Costs 700
Depreciation 100
EBIT $ 200
Interest expense 50
EBT $ 150
Taxes (40%) 60
Net income $ 90

Question 12

Carter Corporation has some money to invest, and its treasurer is choosing between City of Chicago municipal bonds and U.S. Treasury bonds. Both have the same maturity, and they are equally risky and liquid. If Treasury bonds yield 6 percent, and Carter's marginal income tax rate is 40 percent, what yield on the Chicago municipal bonds would make Carter's treasurer indifferent between the two?

Question 13

If a firm's current ratio is less than 1.0, it indicates that:

The firm had negative net income for the year

The firm will be unable to pay its shortterm loans which come due this year

Current Assets are less than Current Liabilities

The firm is insolvent

Question 14

A firm which has a relatively large amount of cash and receivables in its current assets accounts and a relatively small amount of current liabilities would be considered:

Question 15

In November 2011 you bought 100 shares of Microsoft stock for $35.375 a share. In November 2013 you sold your stock for $92.5625 a share. What was your average annual rate of return on your Microsoft investment? (disregard dividends and commissions)

Question 16

You deposit $2,000 in a savings account that pays 10 percent interest, compounded annually. How much will your account be worth in 15 years?

Question 17

You can earn 8 percent interest, compounded annually. How much must you deposit today to withdraw $10,000 in 6 years?

Question 18

Calculate the required rate of return for Mercury, Inc., assuming that the real rate of interest is 3 percent, investors expect a 5 percent rate of inflation in the future, and they expect the rate of return on the overall stock market to be 13 percent. Mercury has a beta of 2.0.

Question 19

Which is the best measure of risk for an asset held in isolation? Which is the best measure for an asset held in a diversified portfolio?

Variance; correlation coefficient

Standard deviation; correlation coefficient

Beta; variance

Coefficient of variation; beta

Beta; beta

Question 20

You have three stocks in your portfolio. $10,000 is invested in a stock with a beta of 1.50 and $15,000 is invested in a stock with a beta of 1.00, and $25,000 is invested in a stock with a beta of 0.50. What is the beta of your portfolio?

Question 21

A corporate bond with a $1,000 face value pays a $50 coupon every six months. The bond will mature in ten years, and has a nominal yield to maturity of 9 percent. What is the price of the bond?

Question 22

The Jones Company has decided to undertake a large project. Consequently, there is a need for additional funds. The financial manager plans to issue preferred stock with a perpetual annual dividend of $5 per share and a par value of $30. If the required return on this stock is currently 20 percent, what should be the stock's market value?

Question 23

A share of common stock has just paid a dividend of $2.00. If the expected long-run growth rate for this stock is 15 percent, and if investors require a 19 percent rate of return, what is the price of the stock?

Question 24

A stock is not expected to pay a dividend over the next four years. Five years from now, the company anticipates that it will establish a dividend of $1.00 per share (i.e., D5 = $1.00). Once the dividend is established, the market expects that the dividend will grow at a constant rate of 5 percent per year forever. The risk-free rate is 5 percent, the company's beta is 1.2, and the market risk premium is 5 percent. The required rate of return on the companyâs stock is expected to remain constant. What is the current stock price?

FIN 612 Chapter Notes - Chapter 2: Relative Risk, Takers, The Globe And Mail

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