Week 4 Assignment 4
MGM 6620 Managerial Finance
Professor: Manuel V. Sicre
Student Name: Zoraya Sandoval
Diversifiable and Nondiversifiable Risks.
In broad terms, why is some risk diversifiable? Why are some risks nondiversifiable? Does it follow that an investor can control the level of unsystematic risk in a portfolio, but not the level of systematic risk? Some of the risk in holding any asset is unique to the asset in question. By investing in a variety of assets, this unsystematic portion of the total risk can be eliminated at little cost. On the other hand, there are systematic risks that affect all investments. This portion of the total risk of an asset cannot be lavishly eliminated. In other words, systematic risk can be controlled, but only by a costly reduction in expected returns. 11.5
Expected Portfolio Returns.
If a portfolio has a positive investment in every asset, can the expected return on the portfolio be greater than that on every asset in the portfolio? Can it be less than that on every asset in the portfolio? If you answer yes to one or both of these questions, give an example to support your answer. No. The portfolio expected return is a weighted average of the asset returns, so it must be less than the largest asset return and greater than the smallest asset return.
Questions and Problems (QP) 11.1, 11.4, 11.8 & 11.13
Determining Portfolio Weight.
What are the portfolio weights for a portfolio that has 90 shares of Stock A that sell for $84 per share and 50 shares of Stock B that sell for $58 per share?
90($84) + 50($58)
WeightA = 90($84)/$10,460
WeightA = .7228
WeightB = 50($58)/$10,460
WeightB = .2772
Portfolio Expected Returns.
You have $10,000 to invest in a stock portfolio. Your choices are Stock X with an expected return of 16 percent and Stock Y with an expected return of 11 percent. If your goal is to create a portfolio with an expected return of 14.25 percent, how much money will you invest in Stock X? In Stock Y?
Investment X = 0.6500($10,000) = $6,500
Investment in Y = (1 – 0.6500) ($10,000) = $3,500
Calculating Expected Returns.
A portfolio is invested 20 percent in Stock G, 35 percent in Stock J, and 45 percent in Stock K. The expected returns on these stocks are 9 percent, 13 percent, and 19 percent, respectively. What is the portfolio’s expected return? How do you interpret your answer?
E(R) = .20(.09) + .35(.13) + .45(.19)
E(R) = 14.90%
A stock as a beta of 0.9, the expected return on the market is 13 percent, and the risk-free rate is 6 percent. What must the expected return on this stock be?
E(Ri) = Rf + [E(RM) – Rf] × bi
E(Ri) = .06 + (.13 – .06)(0.90)
E(Ri) = 12.30%
On the most basic level, if a firm’s WACC is 12 percent, what does this mean? What it means is that the minimum rate of return the firm must earn overall on its existing assets. If the firm earns more than this, value is created. 12.3
If you can borrow all the money you need for a project at 6 percent, doesn’t it follow that 6 percent is your cost of capital for the project? No because the cost of capital depends on the risk of the project, not the source of the money. 12.7
Cost of Debt Estimation.
How do you determine the appropriate cost of debt for a company? Does it make a difference if the company’s debt is privately placed as opposed to being publicly traded? How would you estimate the cost of debt for a firm whose only debt issues are privately held by institutional investors? The appropriate after tax cost of debt to the company is the interest rate it would have to pay if it were to issue new debt today. That’s why, if the YTM on outstanding bonds of the company is observed, the company has an accurate estimate of its...
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