Royal Seattle Investment Club has $100,000 to invest in the equity market. Frasi

Question

Royal Seattle Investment Club has $100,000 to invest in the equity market. Frasier advocates investing the funds in KSEA Radio with a beta of 1.3 and an expected return of 16%. Niles advocates investing the funds in Northwest Medical with a beta of 1.1 and an expected return of 14%. The club is split 50/50 on the two stocks. You are the deciding vote, and you cannot pick a split of $50,000 for each stock. Before you vote, you look up the current risk-free rate (the 1 year U.S. Treasury bill with a yield of 3.75%). Which stock do you select?

Explanation / Answer

Note on Risk - Reward ratio : Wheneven two or more stocks are given with different expeted return & different Beta, we should make the choice for investement on the basis of Risk - Reward ratio. This ratio gives us the relationship between risk present in stock & potential reward for the same stock. The stock with higher Risk - Reward ratio shall be consider for investment.

Formula = (Expected Return - Risk free return ) / Beta

Risk - Reward Ratio for KSEA Radio = (0.16 - 0.0375) / 1.3 = 0.09423

Risk - Reward Ratio for Northwest Medical = (0.14 - 0.0375) / 1.1 = 0.09318

Conclusion : Since Risk - Reward ratio for KESA Ratio is slightly better than Northwest Medical , it is advisable to invest in KESA Ratio

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