1. Consider the following: A firm’s operations are 45% GREATER than an average f

Question

1. Consider the following: A firm’s operations are 45% GREATER than an average firm in the market. Relevant government securities trade @ 3.7%; and the current average return on the market as a whole is 9.1%. What rate of return must the firm pay to attract investors?

2. How does your answer to 1. above change if the company’s operations stabilize and its risk relative to the market goes down to 110%; AND the expected return on the market GOES DOWN to 7.9%?

What is and expected return and variance of a portfolio which is equally weighted in investments of each of the three stocks?

Explanation / Answer

Here the beta() is 145% = 1.45, risk free rate is 3.7% and market return is 9.1%.

Therefore, we use this equation to calculate rate of return of stock (RS):

If companies operation stabilizes then = 1.1

Therefore RS = Rf + (Rm- Rf) = 3.7% + 1.1(7.9%-3.7%) = 8.32%

Returns State of Economy Probability Stock A Stock B Stock C Boom 0.35 0.07 0.15 0.33 Bust 0.65 0.13 0.03 -0.06 Expected returns of Stocks 0.109 0.072 0.0765 therefore expected return of equally weighted portfolio = 0.103*0.33 + 0.072*0.33 + 0.0765*0.34 =

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