Foundation of Finance Questio

Chapter 12: Questions and Problems

#1 Analyze the expert’s answers to the following questions:

a. Question: I have approximately one-third of my investments in stocks, and the rest

in a money market. What do you suggest as a somewhat “safer” place to invest

another one-third? I like to keep one-third accessible for emergencies.

Expert’s answer: Well, you could try 1- or 2-year Treasury bonds. You’d get a little

bit more yield with no risk.

b. Question: Where would you invest if you were to start today? Expert’s answer:

That depends on your age and short-term goals. If you are very young—say, under

40—and don’t need the money you’re investing for a home or college tuition or

such, you would put it in a stock fund. Even if the market tanks, you have time to

#2 Suppose that your 58-year-old father works for the Ruffy Stuffed Toy Company and

has contributed regularly to his company-matched savings plan for the past 15 years.

Ruffy contributes $0.50 for every $1.00 your father puts into the savings plan, up to the

first 6% of his salary. Participants in the savings plan can allocate their contributions

among four different investment choices: a fixed-income bond fund; a “blend” option

that invests in large companies, small companies, and the fixed-income bond fund;

a growth-income mutual fund whose investments do not include other toy companies;

and a fund whose sole investment is stock in the Ruffy Stuffed Toy Company. Over

Thanksgiving vacation, Dad realizes that you have been majoring in finance and

decides to reap some early returns on that tuition money he’s been investing in your

education. He shows you the most recent quarterly statement for his savings plan, and

you see that 98% of its current value is in the fourth investment option, that of the

Ruffy Company stock.

a. Assume that your Dad is a typical risk-averse person who is considering retirement

in five years. When you ask him why he has made the allocation in this way, he

responds that the company stock has continually performed quite well, except for

a few declines that were caused by problems in a division that the company has

long since sold off. In addition, he says, many of his friends at work have done

the same. What advice would you give your dad about adjustments to his plan

allocations? Why?

b. If you consider the fact that your dad works for Ruffy in addition to his 98%

allocation to the Ruffy stock fund, does this make his situation more risky, less

risky, or does it make no difference? Why?

#5. Given the information below about the risks and returns of five alternative portfolios,

plot the risks and returns. Which do not represent efficient portfolios? (SEE END OF TEXTBOOOK CHAPTER 12 QUESTION 5 FOR TABLE)

#7 Consider two assets with expected returns and risk given in the table below.

(SEE END OF TEXTBOOK CHAPTER 12 QUESTION 7 FOR TABLE)

If these asset returns have a correlation coefficient of 0.5, what is the risk and return of

a portfolio equally divided between the two securities? What mix of the two securities

produces the portfolio having the lowest risk? What level of risk is this?

Chapter 13: Questions and Problems

#4. If the Treasury bill rate is currently 0.04 and the expected return to the market

portfolio over the same period is 0.12, determine the risk premium on the market.

If the standard deviation of the return on the market is 0.20, what is the equation

of the Capital Market Line?

#7 If the CAPM is valid, which of the following situations is possible? Explain. Consider

each situation independently

a (SEE END OF TEXBOOK CHAPTER 13 QUESTION 7 FOR TABLE)

b (SEE END OF TEXBOOK CHAPTER 13 QUESTION 7 FOR TABLE)

c (SEE END OF TEXBOOK CHAPTER 13 QUESTION 7 FOR TABLE)

d (SEE END OF TEXBOOK CHAPTER 13 QUESTION 7 FOR TABLE)

#8. Suppose the risk-free rate is 0.10 and a security with a beta of 1 has an equilibrium

expected rate of return of 0.15. What is the equity market premium?

#24 Hint: the capitalization rate you compute with the CAPM- SML equation is the discount rate for the project.

The Clotted Blood Corporation, a home health supply company serving hemophiliacs,

is considering purchasing a new delivery van that will increase the radius of its service

area. For an initial outlay of $21,250 the van is estimated to produce the following

incremental net after-tax cash flows:

(SEE END OF TEXTBOOK CHAPTER 13 QUESTION 24 FOR TABLE)

In capital markets the market risk premium is 0.10 and the risk-free rate is 0.04. If the

stable beta of the company’s stock is 1.25, what is the net present value of the

investment using the estimated market capitalization rate?

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