c. If she were risk-seeking, which investments would she select? Why? If Sharon were risk-seeking, she would select Investment Y and Z since they have a higher risk without an increased return. “The attitude toward risk in which a decreased return would be accepted for an increase in risk” (Gitman, 2009). d. Given the traditional risk preference behavior exhibited by financial managers, which investment would be preferred?
For equity I took the number of shares outstanding times the stock price to get 11503.2 million. For debt not much information was given so I used the 1291. 3. Calculate the costs of equity
Look at the results in Table 1. In general, what is the order of risk for the four risky asset classes? What happens to the reward-to-risk ratio for the different asset classes as the holding period increases? Is this pattern consistent with the change in the optimal allocations for Small Stocks as the holding period increases (shown in Table 2)? Explain.
CAPM: Solutions to Practice Questions Question One Calculate the required rate of return for a risky asset with a ( of 1.75 given an expected return on the market of 14% and a risk free rate of 7%. The required rate of return on the asset is calculated using CAPM: [pic] Question Two Calculate the required rate of return for a risky asset whose correlation with the market is 0.5 given the standard deviation of the stock is 10%, the standard deviation of the market is 15%, the expected return on the market is 11% and the risk free rate is 6%. To calculate the required rate of return for the asset, we must first calculate its beta: [pic] We can now calculate the required rate of return for the asset using CAPM: [pic] Question Three What is the risk free rate of return given the required rate of return on a risky asset with a ( of 2.0 is 16% and the expected return on the market is 12%? We can calculate the risk free rate of return by rearranging the CAPM: [pic] Question Four You are evaluating an investment project that has initial outlay of $10 million and will result in cash flows of $1 million in year 1 and then growing in perpetuity at 4%. The firm has a ( of 0.75 but this project is twice as risky as the firm’s normal operations.
The company regularly calculated “warranted equity value” for its common shares and repurchased its stock whenever the market price fell substantially below that value. The cost of capital for Marriott and for each of the three divisions individually could differ in each of the divisions resulting in varying cost of capital. In order for Marriott to only invest in a project, the internal rate of return (IRR) needs to be greater than the hurdle rate. To accurately determine the opportunity cost of capital. We will apply the cost of capital as the hurdle rate to discount future cash flows for the investment projects of the firm’s three divisions.
What conclusions can you draw from all this? Coefficient of RM-RF is a measure of the exposure a fund has to market risk. The coefficients of RM-RF of all funds are close to 1. That means the impact on returns from market factors may be less than impact from value factors. SMB denotes the risk factor associated with firm size.
- How can cost of equity be estimated without comparable public companies. 3. Analysis / Result: Let us consider and analyze the above mentioned points. Also refer to the Excel Sheet – Marriott; What risk-free rate and risk premium should be used for cost of equity: To increase shareholder value MC use shareholders’ measure to estimate the cost of equity, which is Capital Asset Pricing Model (CAPM). According to the CAPM, the cost of equity is found by; Cost of equity = (equity / capital) x [ Risk free rate + (Beta x Risk premium) ] Risk free rate is the rate of return expected
Book to market ratio was the most powerful scaled price variable for predicting stock returns (more than PE and A/ME). - Size effect exists. - High BE/ME ~ value stocks. Low BE/ME ~ growth stocks - growth were typically overhyped? that did not go well with efficient markets hypothesis.
Notice that if Han chooses a limit price strategy, Coa can earn $1.5 billion rather than $1 billion by also charging a limit price. If Han chooses to charge monopoly prices, Coa can earn $2.5 billion rather than $1.75 billion by charging limit prices. Irrespective of the pricing strategy chosen by Han, Coa is better off charging limit prices. Limit pricing is a dominant strategy for Coa. The same holds true for Han.
YTM call = YTM non callable + risk premium Determined by ability of being called, and how much of risk. It would cost to create the synthetic bond $ 98.783. Ask ( Price at which Issuer / Dealer is willing to sell the bond for. Bid ( Price at which Issuer/Dealer is willing to buy the bond. | | | | | | | | | |Treasury Bonds | | | | | | | | |Ask |Bid |Coupon | | | |81/4 May 00-05 |101.25 |101.125 |4.125 | | | |12-May-05 | |129.9063 |129.7188 |6 | | | |8 7/8 May 00 |104.5 |104.375 |4.4375 | | | | | | | | | | | |STRIPS | | | | | | | | | | | |