Chapter 8 risk and rates of return problem solutions

18.12.2020 By Mujora

Capital budgeting is the process of deciding which long-term projects the firm should undertake. Examples may include:. Mutually exclusive projects are any set of projects in which choosing one makes the other projects no longer possible. For example, we are considering upgrading our printing press and have the choice of two alternatives.

The first is a low-cost model that will need replaced in 3-years and the second is a more expensive model that will need replaced in 5-years. We can only choose one of these options, so they are mutually exclusive. When we have mutually exclusive projects, our decision rule needs to not only decide if a project is good or bad, but needs to be able to rank which project is the best. Independent sometimes called stand-alone projects are any set of projects in which choosing one has no impact on our decision to choose another project from that set.

For example, McBurger Inc. The first is a new deep frying system for their french fries. The second is a new order placement system for the drive-thru. McBurger could choose to take the new deep fryer or the new order placement, or it could choose both. Taking one project does not influence the other, so they are independent. When we have independent projects, our decision rule does not need to rank which project is the best, but merely identify if the project is good or bad.

Many decisions made by the firm are neither independent nor mutually exclusive, but are instead interdependent. In this case, the decision to take one project impacts our decision to take another, but they are not mutually exclusive.

For example, VideogamesPlus may decide to introduce a new video game machine along with some games for the new system.

The two projects are not independent the game machine will sell better with more games available nor mutually exclusive producing the games does not preclude producing the game machine.

However, they are interdependent in that each project will perform better if both are produced. Some interdependent projects are compliments like the example above in which the cash flows from both projects taken together are greater than the cash flows from each project on a standalone basis.

Other interdependent projects are substitutes in which the cash flows from both projects taken together are less than the cash flows from each project on a standalone basis.

While we will not be evaluating interdependent projects in this class, the procedure is to look at each project individually as well as in combination. Some decision rules such as the Payback Period stop considering cash flows after a certain cutoff point.

This may result in us making a poor decision, especially when trying to choose between two or more mutually exclusive projects. We also should note that it is important to be careful about evaluating relevant cash flows.

For instance, consider your decision to attend college as a capital budgeting decision. It is easy to underestimate the cost if you do not acknowledge that you could be earning income during the time you spend in class and on homework.

This is an opportunity cost and is just as important as actual dollars spent. Since capital budgeting projects are long-term investments, the cash flows which they generate are likely to take place years into the future. Instead, the project has caused a significant reduction in firm value.

As we have discussed since chapter one, investors are risk averse. Therefore, the riskier the projects that the firm invests in, the higher the rate of return they must earn to satisfy stockholders. This is something to be careful about. All decision rules will rank projects in some manner. However, if we are going to focus on maximizing shareholder wealth, then we want to rank projects based on how they add value to the firm.

The more value the project generates, the more wealth is generated for our shareholders.On the basis of expected Rate, Standard Deviation, Variance and Coefficient of variation decided which of the following company is best for investment Single company Risk analysis. Following are the probability distribution of returns of portfolio of Stock A and Stock B in equal proportion of weight in each state of economy.

You are required to calculate Expected Return and Risk for individual Stocks? If you deposit Rs.

chapter 8 risk and rates of return problem solutions

Suppose that the inflation rate during the year is also 6 percent. Find real amount in Rupees? You save Rs. Suppose the current market value of Rs. Find expected Rate of Return? Future Value and Present Value Tables. Principles of Accounting.

Cost Accounting. Principles of Finance. Financial Accounting. Your email address will not be published. Save my name, email, and website in this browser for the next time I comment. Submit Comment. Problem 2: Following are the probability distribution of returns of portfolio of Stock A and Stock B in equal proportion of weight in each state of economy.

Problem 3: If you deposit Rs. Search here… Search for:. Facebook Handle. Present Annuity Prob. Cash Book Three Col.

What is Capital Budgeting?

Submit a Comment Cancel reply Your email address will not be published.What is the required return for the overall stock market? What is the required rate of return on a stock with a beta of 0. To determine: The required rate of return for overall stock market and for the given beta value.

The required rate of return is the rate which should be the minimum earning on an investment to keep that investment running in the market. When the required return is earned only then the users and the companies invest in that particular investment. Substitute 3. Bartleby provides explanations to thousands of textbook problems written by our experts, many with advanced degrees! Subscribe Sign in. Operations Management. Chemical Engineering. Civil Engineering.

Computer Engineering. Computer Science. Electrical Engineering. Mechanical Engineering. Advanced Math. Advanced Physics. Earth Science. Social Science. Fundamentals of Financial Manageme Chapter Questions. Problem 1Q.

chapter 8 risk and rates of return problem solutions

Problem 2Q. Problem 3Q. Problem 4Q. Problem 5Q. Problem 6Q. Problem 7Q. Problem 8Q. Problem 9Q. Problem 1P.To browse Academia. Skip to main content. Log In Sign Up.

Gm marine parts

Quinton Jackson. Answer: c 2. Which is the best measure of risk for a single asset held in isolation, and 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. Answer: d 3. A highly risk-averse investor is considering adding one additional stock to a 3-stock portfolio, to form a 4- stock portfolio. Which stock should this investor add to his or her portfolio, or does the choice not matter? Either A or B, i. Stock A. Stock B. Neither A nor B, as neither has a return sufficient to compensate for risk.

Add A, since its beta must be lower. Answer: c With only 4 stocks in the portfolio, unsystematic risk matters, and B has less. Which of the following is NOT a potential problem when estimating and using betas, i. The fact that a security or project may not have a past history that can be used as the basis for calculating beta.

Sometimes, during a period when the company is undergoing a change such as toward more leverage or riskier assets, the calculated beta will be drastically different from the "true" or "expected future" beta.

The beta of an "average stock," or "the market," can change over time, sometimes drastically. Sometimes the past data used to calculate beta do not reflect the likely risk of the firm for the future because conditions have changed.

All of the statements above are true. Answer: c 5. Stock A's beta is 1. Which of the following statements must be true about these securities?What is the required rate of return on a stock with a beta of 2? The required rate of return is the rate which should be the minimum earnings on an investment to keep that investment running in the market.

Fundamentals of Corporate Finance: Chapter 8 Problems (2016)

When the required return is earned only then the users and the companies invest in that particular investment. Bartleby provides explanations to thousands of textbook problems written by our experts, many with advanced degrees! Subscribe Sign in. Operations Management. Chemical Engineering. Civil Engineering. Computer Engineering. Computer Science. Electrical Engineering. Mechanical Engineering.

Advanced Math. Advanced Physics. Earth Science. Social Science. Fundamentals Of Financial Manageme Chapter Questions. Problem 1Q. Problem 2Q. Problem 3Q.

Tsa approved power bank

Problem 4Q. Problem 5Q. Problem 6Q. Problem 7Q. Problem 8Q. Problem 9Q. Problem 10Q. Problem 11Q. Problem 1P. Problem 2P. Problem 3P. Problem 4P. Problem 5P.To browse Academia. Skip to main content. Log In Sign Up. Mida Katari. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Lecture Suggestions Risk analysis is an important topic, but it is difficult to teach at the introductory level.

Drop d songs

We just try to give students an intuitive overview of how risk can be defined and measured, and leave a technical treatment to advanced courses. Our primary goals are to be sure students understand 1 that investment risk is the uncertainty about returns on an asset, 2 the concept of portfolio risk, and 3 the effects of risk on required rates of return. Answers to End-of-Chapter Questions a.

If the actual inflation rate is greater than that expected, interest rates in general will rise to incorporate a larger inflation premium IP and—as we saw in Chapter 7—the value of the portfolio would decline. Ivan would be subject to reinvestment risk. The U. Treasury currently issues indexed bonds. The probability distribution for complete certainty is a vertical line. The expected return on a life insurance policy is calculated just as for a common stock.

Each outcome is multiplied by its probability of occurrence, and then these products are summed. This expected return could be compared to the premium paid.

Generally, the premium will be larger because of sales and administrative costs, and insurance company profits, indicating a negative expected rate of return on the investment in the policy.

In fact, these events death and future lifetime earnings capacity are mutually exclusive. People are generally risk averse.

chapter 8 risk and rates of return problem solutions

Therefore, they are willing to pay a premium to decrease the uncertainty of their future cash flows. In practice, however, it may be impossible to find individual stocks that have a nonpositive beta.

In this case it would also be impossible to have a stock portfolio with a zero beta.

Contemporary british plays

Even if such a portfolio could be constructed, investors would probably be better off just purchasing Treasury bills, or other zero beta investments.

The product rM — rRF bj is the risk premium of the jth stock. If bj is low say, 0. However, if bj is large say, 2. A decrease in risk aversion will decrease the return an investor will require on stocks. Thus, prices on stocks will increase because the cost of equity will decline.

What is Capital Budgeting?

With a decline in risk aversion, the risk premium will decline as compared to the historical difference between returns on stocks and bonds. N a. If Stock Y is less highly correlated with the market than X, then it might have a lower beta than Stock X, and hence be less risky in a portfolio sense. If rM is The difference in their required returns is: No changes occur.

Falls to 8. Risk averter.To login with Google, please enable popups. Sign up. To signup with Google, please enable popups. Sign up with Google or Facebook. To sign up you must be 13 or older. Terms of Use and Privacy Policy. Already have an account? Log in. Get started today! Edit a Copy. Study these flashcards. Julio A. What is risk and how do we measure it? We define risk as the chance that something other than what is expected occurs—that is, variability of returns. It is measured individually with stand alone or as a group of investments in a portfolio as portfolio risk.

How does the risk of an investment held in isolation differ from the risk of the same investment held in a portfolio? What is portfolio risk? In isolation an investment can't do anything to improve while in a portfolio they have different Assets to hopefully reduce risk.

How does risk affect rates of return? Why do we generally divide total risk into two components—systematic risk and unsystematic risk? Which component is diversifiable? How is Expected rate of return computed?

What are the basic risks that are included in the risk premium associated with a debt instrument? The part of the return on an investment that can be attributed to the risk of the investment. Stay Swift Corp. The expected returns from the stocks in different market conditions are given below. Nytex Corp.