You have recently graduated with a major in finance and landed a financial plann

Question

You have recently graduated with a major in finance and landed a financial planner job with Barney Smith Inc., a large financial services corporation. Your first assignment is to invest $100,000 for a client. Because the funds will be invested in a new business the client plans to start at the end of the year, you have been instructed to plan for a 1-year holding period. Further, your boss has restricted you to the investment alternatives shown in Table 1 on the attached resource, "Topic 5 Assignment Graphic Tables." (Disregard for now the items at the bottom of the data; you will fill in the blanks later.) Note that the estimated returns of American Foam (Am. Foam), a bedding company, do not always move in the same direction as the overall economy. For example, when the economy is below average, consumers purchase fewer mattresses than they would if the economy were stronger. However, if the economy is in a flat-out recession, a large number of consumers who were planning to purchase a more expensive inner-spring mattress may purchase a cheaper foam mattress instead. Under these circumstances, we would expect American Foam’s stock price to be higher if there is a recession than if the economy was just below average. Barney Smith’s economic forecasting staff has developed probability estimates for the state of the economy, and its security analysts have developed a sophisticated computer program that was used to estimate the rate of return on each alternative under several state of the economy scenarios. Alta Industries (Alta Inds) is an electronics firm; Repo Men collects past-due debts; and American Foam, as per above, manufactures mattresses and various other foam products. Barney Smith also maintains an "index fund" which owns a market-weighted fraction of all publicly traded stocks; you can invest in that fund, and thus obtain average stock market results. Given the situation as described, answer the following questions. 1. Describe investment returns, and what "best case" and "worst case" returns you might hope to achieve for your new client. What is the return on an investment that costs $1,000 and is sold after one year for $1,100? Would you recommend this type of investment for your task at hand? 2. Explain why the Treasury bill's (aka, T-bill) return is independent of the state of the overall economy? Do T-bills promise a completely risk-free return? Provide your rationale. 3. Why are Alta Ind.’s returns expected to move with the economy whereas Repo Men’s are expected to move counter to the economy? 4. Calculate the expected return (), the standard deviation (p), and the coefficient of variation (CVp) for the portfolio profiled in Table 1. Provide your answers with calculations.

Explanation / Answer

A)The financial results of an investments is quantified as the investment returns.It is expressed  either by the country ‘s currency or percentage . Best Case returns are when positive returns are earned on the sold investment and Worst case returns are when negative returns are earned on the sold investment.The returns in terms of dollar and percentage  is $1,100 - $1,000 = $100. $100/$1,000 = 0.10 = 10%.

         B) T-bill’s return are independent of the state of the economy as the treasury bills would be redeemed the bills at par irrespective of the current situation of the economy ie whether there is inflation or deflation in the economy .They are not risk free return as rates offered by the T bills comprise of real risk-free rate and inflation premium,. If there any increase or decrease in the inflation rate then realized real rate of return would also increase or decrease. In terms of purchasing power T bills are not risk less. If rates fall nominal income would fall thus exposing reinvestment rate risk.

C) Alta Industries’ are dependent on the economy hence have positive correlation with it  reason being the firm’s sales, and hence profits, will increase or decrease as the economy goes up or down. On the other hand, Repo Men is considered by many investors to be a hedge against both bad times and high inflation,  Repo Men are thus negatively correlated the economy.

D)The expected rate of return, , is calculated as

Alta Inds= 0.1(-22.0%) + 0.2(-2.0%) + 0.4(20.0%) + 0.2(35.0%) +     0.1(50.0%)

= 17.4%.

T-bills =  8.0%.

Repo Men =  1.7%.

Am Foam = 13.8%.

M = 15.0%.

The standard deviation is calculated as follows

Alta = [(-22.0 - 17.4)2(0.1) + (-2.0 - 17.4)2(0.2) + (20.0 - 17.4)2(0.4)

             + (35.0 - 17.4)2(0.2) + (50.0 - 17.4)2(0.1)]0.5

           =  = 20.0%.

Here are the standard deviations for the other alternatives:

T-bills =  0.0%.

Repo = 13.4%.

AmFoam = 18.8%.

     M = 15.3%.

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