Case #84 Risk and Rates of Return - Filmore Enterprises

Case #84

Risk and Rates of Return – Filmore Enterprises

Summary 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 business to incorporate a cyber-café and has decided to partner with Randy Morely, who owns Morely Distributors (a local beverage distributor). Kathy and Randy both have the majority of their finances tied up in their respective businesses, and have asked for analysts to prepare a discussion on the risk and return issues surrounding this new business venture.

Question 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 CPC, Morely, and EAT.

 

 Question 3

Basing a decision solely on expected returns is appropriate only for risk-neutral individuals. Since most people are risk averse, risk is an important consideration for the decision.

a. Two possible measures of risk are the standard deviation and the coefficient of variation. Calculate the standard deviation and coefficient of variation for CPC returns andcomplete the related blanks in Table1.

b. Compare the risk and expected return relationships among all six assets listed in Table 1 (make a table). Explain the apparent discrepancies with the normal risk and returntradeoff.

 

Question 4

Suppose investors create a 2-stock portfolio by investing $100,000 in CPC and $100,000 in Morely.

a. Calculate the expected return for each state of the economy, and the compute theexpected return for the portfolio. Complete the related blanks in Table2.

b. Compute the standard deviation for the portfolio, and compare it to the standard deviationof the individual stocks. Complete the related blanks in Table2.

c. In general, how would risk be affected if you formed another portfolio composed of CPCand EAT? Explain how the correlation coefficient affects the level of diversification in the CPC- Morely and the CPC-EATportfolios.

 

Question 5

Suppose an investor has a portfolio consisting of just one randomly-selected stock. What happens to the risk as the investor adds more and more randomly-selected stocks to the portfolio?

Illustrate your answer with a graph showing “portfolio standard deviation” on the vertical axis and “number of stocks” on the horizontal axis.

 

Question 7

Change Table 1 by substituting Year 1 through Year 5 for the states of the economy.

a. Plot the characteristic lines for CPC, Morely, and T-bills showing the returns on the index(the market) on the x-axis and the returns on the asset on y-axis. Estimate (by visual inspection) the slope for each line. If you are using the spreadsheet model, compute the slope coefficients. How do these compare to the betas provided in Table1?

b. What is the significance of the distance between the plot points and the regression line, thatis, theerrors?

c. What do betas measure, and how are they used in riskanalysis?

d. Develop a table depicting the beta and expected return for each security, determined fromthe data provided by the investment bankers. Does the risk and return relationship appear reasonable relative to themarket?

 

Question 8

Using T-bonds as a risk-free rate and the NASDAQ index as the market,

a. Plot the Security Market Line(SML).

 b. Calculate the required rate of return for CPC, Morely, and EAT based on the SML. Compare the required return from the SML with the expected return from Question 1. Explain the decision to either buy or sell each of the stocks, give thisinformation.

c. Are the stocks in equilibrium? If not, how would equilibrium berestored?

 

Question 9

Filmore Enterprises is expected to be similar to a company composed of 40% CPC and 60% EAT.

a. Compute the beta coefficient for a 40/60 portfolio of CPC-EAT and then determine its required rate of return. How does the required return compare with the expected return from Table 2? Explain why you would or would not purchase this portfolio.

Question 10

The SML might shift in response to various economic changes. A change in the SML affects security prices and rates of return.

a. Suppose investors raised their expectations for inflation by 4 percentage points overcurrent estimates as reflected in the 5.2% T-bond rate. Explain the effect this would have on the SML and on the returns required on high –versus low-risksecurities.

b. Disregard Question 10a and assume that investor’s risk aversion increased enough to cause the market risk premium to rise by 4 percentage points. Explain what effect this would have on the SML and on returns of high-risk versuslow-risk.

c. Discuss the kinds of changes Question 10a and 10b would have on short-run and long-run effects; for example, might an increase in expected inflation lead to lower returns in the shortrun followed by higher returns in the longrun?