„ Solutions to Problems

( Pt − Pt −1 + Ct )
P5-1. LG 1: Rate of return: rt =
Pt −1
Basic
($21,000 − $20,000 + $1,500)
a. Investment X: Return = = 12.50%
$20,000
($55,000 − $55,000 + $6,800)
Investment Y: Return = = 12.36%
$55,000
b. Investment X should be selected because it has a higher rate of return for the same level
of risk.

(Pt − Pt −1 + Ct )
P5-2. LG 1: Return calculations: rt =
Pt −1
Basic
Investment Calculation rt(%)
A ($1,100 − $800 − $100) ÷ $800 25.00
B ($118,000 − $120,000 + $15,000) ÷ $120,000 10.83
C ($48,000 − $45,000 + $7,000) ÷ $45,000 22.22
D ($500 − $600 + $80) ÷ $600 −3.33
E ($12,400 − $12,500 + $1,500) ÷ $12,500 11.20

P5-3. LG 1: Risk preferences

Intermediate
The risk-averse manager would accept Investment X because it provides the highest return and
has the lowest amount of risk. Investment X offers an increase in return for taking on more risk
than what the firm currently earns.

P5-4. LG 2: Risk analysis

Intermediate
a.
Expansion Range
A 24% − 16% = 8%
B 30% − 10% = 20%
b. Project A is less risky, since the range of outcomes for A is smaller than the range for
Project B.
c. Since the most likely return for both projects is 20% and the initial investments are equal, the
answer depends on your risk preference.
d. The answer is no longer clear, since it now involves a risk–return tradeoff. Project B has a
slightly higher return but more risk, while A has both lower return and lower risk.
 Chapter 5 Risk and Return 91

P5-5. LG 2: Risk and probability

Intermediate
a.
Camera Range
R 30% − 20% = 10%
S 35% − 15% = 20%

b.
Possible Probability Expected Return Weighted
Outcomes Pri ri Value (%)(ri × Pri)
Camera R Pessimistic 0.25 20 5.00
Most likely 0.50 25 12.50
Optimistic 0.25 30 7.50
1.00 Expected return 25.00
Camera S Pessimistic 0.20 15 3.00
Most likely 0.55 25 13.75
Optimistic 0.25 35 8.75
1.00 Expected return 25.50

c. Camera S is considered more risky than Camera R because it has a much broader range of
outcomes. The risk–return tradeoff is present because Camera S is more risky and also
provides a higher return than Camera R.

P5-6. LG 2: Bar charts and risk

Intermediate
a.
92 Gitman • Principles of Managerial Finance, Brief Fifth Edition

b.
Market Probability Expected Return Weighted Value
Acceptance Pri ri (ri × Pri)
Line J Very Poor 0.05 0.0075 0.000375
Poor 0.15 0.0125 0.001875
Average 0.60 0.0850 0.051000
Good 0.15 0.1475 0.022125
Excellent 0.05 0.1625 0.008125
1.00 Expected return 0.083500
Line K Very Poor 0.05 0.010 0.000500
Poor 0.15 0.025 0.003750
Average 0.60 0.080 0.048000
Good 0.15 0.135 0.020250
Excellent 0.05 0.150 0.007500
1.00 Expected return 0.080000

c. Line K appears less risky due to a slightly tighter distribution than Line J, indicating a lower
range of outcomes.

σr
P5-7. LG 2: Coefficient of variation: CV =
r
Basic
7%
a. A CVA = = 0.3500
20%
9.5%
B CVB = = 0.4318
22%
6%
C CVC = = 0.3158
19%
5.5%
D CVD = = 0.3438
16%
b. Asset C has the lowest coefficient of variation and is the least risky relative to the other choices.
 Chapter 5 Risk and Return 93

P5-8. LG 2: Personal finance: Rate of return, standard deviation, coefficient of variation

Challenge

a. Stock Price Variance

Year Beginning End Returns (Return–Average Return)2
2006 14.36 21.55 50.07% 0.0495
2007 21.55 64.78 200.60% 1.6459
2008 64.78 72.38 11.73% 0.3670
2009 72.38 91.80 26.83% 0.2068

b. Average return 2.31%

c. Sum of variances 2.2692
3 Sample divisor (n − 1)
0.7564 Variance
86.97% Standard deviation
d. 1.20 Coefficient of variation
e. The stock price of Apple has definitely gone through some major price changes over this
time period. It would have to be classified as a volatile security having an upward price
trend over the past 4 years. Note how comparing securities on a CV basis allows the investor
to put the stock in proper perspective. The stock is riskier than what Mike normally buys but
if he believes that Apple will continue to rise then he should include it.

P5-9. LG 2: Assessing return and risk

Challenge
a. Project 257
(1) Range: 1.00 − (−0.10) = 1.10
n
(2) Expected return: r = ∑ ri × Pri
i =1

Expected Return
n
Rate of Return Probability Weighted Value r = ∑ ri × Pri
ri Pri ri × Pri i=1

−0.10 0.01 −0.001

0.10 0.04 0.004
0.20 0.05 0.010
0.30 0.10 0.030
0.40 0.15 0.060
0.45 0.30 0.135
0.50 0.15 0.075
0.60 0.10 0.060
0.70 0.05 0.035
0.80 0.04 0.032
1.00 0.01 0.010
1.00 0.450
94 Gitman • Principles of Managerial Finance, Brief Fifth Edition

n
(3) Standard deviation: σ = ∑ (r − r )
i =1
i
2
× Pri

ri r ri − r ( ri − r )2 2 Pr i ( ri − r )2 × Pri

−0.10 0.450 −0.550 0.3025 0.01 0.003025

0.10 0.450 −0.350 0.1225 0.04 0.004900
0.20 0.450 −0.250 0.0625 0.05 0.003125
0.30 0.450 −0.150 0.0225 0.10 0.002250
0.40 0.450 −0.050 0.0025 0.15 0.000375
0.45 0.450 0.000 0.0000 0.30 0.000000
0.50 0.450 0.050 0.0025 0.15 0.000375
0.60 0.450 0.150 0.0225 0.10 0.002250
0.70 0.450 0.250 0.0625 0.05 0.003125
0.80 0.450 0.350 0.1225 0.04 0.004900
1.00 0.450 0.550 0.3025 0.01 0.003025
0.027350

σ Project 257 = 0.027350 = 0.165378

0.165378
(4) CV = = 0.3675
0.450
b. Project 432
(1) Range: 0.50 − 0.10 = 0.40
n
(2) Expected return: r = ∑ ri × Pri
i =1

Expected Return
n
r = ∑ ri × Pri
Rate of Return Probability Weighted Value
ri Pri ri × Pri i =1

0.10 0.05 0.0050

0.15 0.10 0.0150
0.20 0.10 0.0200
0.25 0.15 0.0375
0.30 0.20 0.0600
0.35 0.15 0.0525
0.40 0.10 0.0400
0.45 0.10 0.0450
0.50 0.05 0.0250
1.00 0.300
 Chapter 5 Risk and Return 95

n
(3) Standard deviation: σ = ∑ (r − r )
i =1
i
2
× Pri

ri r ri − r ( ri − r )2 Pri ( ri − r )2 × Pri
0.10 0.300 −0.20 0.0400 0.05 0.002000
0.15 0.300 −0.15 0.0225 0.10 0.002250
0.20 0.300 −0.10 0.0100 0.10 0.001000
0.25 0.300 −0.05 0.0025 0.15 0.000375
0.30 0.300 0.00 0.0000 0.20 0.000000
0.35 0.300 0.05 0.0025 0.15 0.000375
0.40 0.300 0.10 0.0100 0.10 0.001000
0.45 0.300 0.15 0.0225 0.10 0.002250
0.50 0.300 0.20 0.0400 0.05 0.002000
0.011250

σProject 432 = 0.011250 = 0.106066

0.106066
(4) CV = = 0.3536
0.300
c. Bar Charts
96 Gitman • Principles of Managerial Finance, Brief Fifth Edition

d. Summary statistics

Project 257 Project 432

Range 1.100 0.400
Expected return (r ) 0.450 0.300
Standard deviation (σ r ) 0.165 0.106
Coefficient of variation (CV) 0.3675 0.3536

Since Projects 257 and 432 have differing expected values, the coefficient of variation should
be the criterion by which the risk of the asset is judged. Since Project 432 has a smaller CV, it
is the opportunity with lower risk.

P5-10. LG 2: Integrative–expected return, standard deviation, and coefficient of variation

Challenge
n
a. Expected return: r = ∑ ri × Pri
i =1

Expected Return
n
Rate of Return Probability Weighted Value r = ∑ ri × Pri
ri Pri ri × Pri i =1

Asset F 0.40 0.10 0.04

0.10 0.20 0.02
0.00 0.40 0.00
−0.05 0.20 −0.01
−0.10 0.10 −0.01
0.04
Asset G 0.35 0.40 0.14
0.10 0.30 0.03
−0.20 0.30 −0.06
0.11
Asset H 0.40 0.10 0.04
0.20 0.20 0.04
0.10 0.40 0.04
0.00 0.20 0.00
−0.20 0.10 −0.02
0.10

Asset G provides the largest expected return.

 Chapter 5 Risk and Return 97

n
b. Standard deviation: σ = ∑ (r − r )
i =1
i
2
xPri

ri − r ( ri − r ) 2 Pr i σ2 σr

Asset F 0.40 − 0.04 = 0.36 0.1296 0.10 0.01296

0.10 − 0.04 = 0.06 0.0036 0.20 0.00072
0.00 − 0.04 = −0.04 0.0016 0.40 0.00064
−0.05 − 0.04 = −0.09 0.0081 0.20 0.00162
−0.10 − 0.04 = −0.14 0.0196 0.10 0.00196
0.01790 0.1338
Asset G 0.35 − 0.11 = 0.24 0.0576 0.40 0.02304
0.10 − 0.11 = −0.01 0.0001 0.30 0.00003
−0.20 − 0.11 = −0.31 0.0961 0.30 0.02883
0.05190 0.2278
Asset H 0.40 − 0.10 = 0.30 0.0900 0.10 0.009
0.20 − 0.10 = 0.10 0.0100 0.20 0.002
0.10 − 0.10 = 0.00 0.0000 −0.40 0.000
0.00 − 0.10 = −0.10 0.0100 0.20 0.002
−0.20 − 0.10 = −0.30 0.0900 0.10 0.009
0.022 0.1483

Based on standard deviation, Asset G appears to have the greatest risk, but it must be measured
against its expected return with the statistical measure coefficient of variation, since the three
assets have differing expected values. An incorrect conclusion about the risk of the assets
could be drawn using only the standard deviation.
standard deviation (σ )
c. Coefficient of variation =
expected value
0.1338
Asset F: CV = = 3.345
0.04
0.2278
Asset G: CV = = 2.071
0.11
0.1483
Asset H: CV = = 1.483
0.10
As measured by the coefficient of variation, Asset F has the largest relative risk.
98 Gitman • Principles of Managerial Finance, Brief Fifth Edition

P5-11. LG 3: Personal finance: Portfolio return and standard deviation

Challenge
a. Expected portfolio return for each year: rp = (wL × rL) + (wM × rM)

Expected
Asset L Asset M Portfolio Return
Year (wL × rL) + (wM × rM) rp
2010 (14% × 0.40 = 5.6%) + (20% × 0.60 = 12.0%) = 17.6%
2011 (14% × 0.40 = 5.6%) + (18% × 0.60 = 10.8%) = 16.4%
2012 (16% × 0.40 = 6.4%) + (16% × 0.60 = 9.6%) = 16.0%
2013 (17% × 0.40 = 6.8%) + (14% × 0.60 = 8.4%) = 15.2%
2014 (17% × 0.40 = 6.8%) + (12% × 0.60 = 7.2%) = 14.0%
2015 (19% × 0.40 = 7.6%) + (10% × 0.60 = 6.0%) = 13.6%

∑w
j =1
j × rj
b. Portfolio return: rp = Return
n

17.6 + 16.4 + 16.0 + 15.2 + 14.0 + 13.6

rp = = 15.467 = 15.5%
6
c. Standard deviation:
n
(ri − r )2
σ rp = ∑
i =1 ( n − 1)

⎡(17.6% − 15.5%)2 + (16.4% − 15.5%)2 + (16.0% − 15.5%)2 ⎤

⎢ 2⎥
⎣ + (15.2% − 15.5%) + (14.0% − 15.5%) + (13.6% − 15.5%) ⎦
2 2
σ rp =
6 −1
⎡(2.1%)2 + (0.9%)2 + (0.5%)2 ⎤
⎢ 2⎥
⎣ + (−0.3%) + (−1.5%) + (−1.9%) ⎦
2 2
σ rp =
5

(.000441 + 0.000081 + 0.000025 + 0.000009 + 0.000225 + 0.000361)

srp =
5
0.001142
σ rp = = 0.000228% = 0.0151 = 1.51%
5

d. The assets are negatively correlated.

e. Combining these two negatively correlated assets reduces overall portfolio risk.
 Chapter 5 Risk and Return 99

P5-12. LG 3: Portfolio analysis

Challenge
a. Expected portfolio return:
Alternative 1: 100% Asset F

16% + 17% + 18% + 19%

rp = = 17.5%
4

Alternative 2: 50% Asset F + 50% Asset G

Asset F Asset G Portfolio Return
Year (wF × rF) + (wG × rG) rp
2010 (16% × 0.50 = 8.0%) + (17% × 0.50 = 8.5%) = 16.5%
2011 (17% × 0.50 = 8.5%) + (16% × 0.50 = 8.0%) = 16.5%
2012 (18% × 0.50 = 9.0%) + (15% × 0.50 = 7.5%) = 16.5%
2013 (19% × 0.50 = 9.5%) + (14% × 0.50 = 7.0%) = 16.5%

16.5% + 16.5% + 16.5% + 16.5%

rp = = 16.5%
4

Alternative 3: 50% Asset F + 50% Asset H

Asset F Asset H Portfolio Return
Year (wF × rF) + (wH × rH) rp
2010 (16% × 0.50 = 8.0%) + (14% × 0.50 = 7.0%) 15.0%
2011 (17% × 0.50 = 8.5%) + (15% × 0.50 = 7.5%) 16.0%
2012 (18% × 0.50 = 9.0%) + (16% × 0.50 = 8.0%) 17.0%
2013 (19% × 0.50 = 9.5%) + (17% × 0.50 = 8.5%) 18.0%

15.0% + 16.0% + 17.0% + 18.0%

rp = = 16.5%
4
b. Standard deviation:
n
(ri − r )2
(1) σ rp = ∑
i =1 ( n − 1)

[(16.0% − 17.5%)2 + (17.0% − 17.5%)2 + (18.0% − 17.5%)2 + (19.0% − 17.5%)2 ]

σF =
4 −1

[(−1.5%)2 + (−0.5%)2 + (0.5%)2 + (1.5%)2 ]

σF =
3

(0.000225 + 0.000025 + 0.000025 + 0.000225)

σF =
3

0.0005
σF = = .000167 = 0.01291 = 1.291%
3
100 Gitman • Principles of Managerial Finance, Brief Fifth Edition

[(16.5% − 16.5%)2 + (16.5% − 16.5%)2 + (16.5% − 16.5%)2 + (16.5% − 16.5%)2 ]

(2) σ FG =
4 −1
[(0)2 + (0)2 + (0)2 + (0)2 ]
σ FG =
3
σ FG = 0
[(15.0% − 16.5%)2 + (16.0% − 16.5%)2 + (17.0% − 16.5%)2 + (18.0% − 16.5%)2 ]
(3) σ FH =
4 −1

[(−1.5%)2 + (−0.5%)2 + (0.5%)2 + (1.5%)2 ]

σ FH =
3

[(0.000225 + 0.000025 + 0.000025 + 0.000225)]

σ FH =
3

0.0005
σ FH = = 0.000167 = 0.012910 = 1.291%
3
c. Coefficient of variation:
CV = σ r ÷ r
1.291%
CVF = = 0.0738
17.5%
0
CVFG = =0
16.5%
1.291%
CVFH = = 0.0782
16.5%
d. Summary:

rp: Expected Value

of Portfolio σrp CVp
Alternative 1 (F) 17.5% 1.291% 0.0738
Alternative 2 (FG) 16.5% 0 0.0
Alternative 3 (FH) 16.5% 1.291% 0.0782

Since the assets have different expected returns, the coefficient of variation should be used to
determine the best portfolio. Alternative 3, with positively correlated assets, has the highest
coefficient of variation and therefore is the riskiest. Alternative 2 is the best choice; it is
perfectly negatively correlated and therefore has the lowest coefficient of variation.
 Chapter 5 Risk and Return 101

P5-13. LG 4: Correlation, risk, and return

Intermediate
a. (1) Range of expected return: between 8% and 13%
(2) Range of the risk: between 5% and 10%
b. (1) Range of expected return: between 8% and 13%
(2) Range of the risk: 0 < risk < 10%
c. (1) Range of expected return: between 8% and 13%
(2) Range of the risk: 0 < risk < 10%

P5-14. LG 1, 4: Personal finance: International investment returns

Intermediate
24,750 − 20,500 4,250
a. Returnpesos = = = 0.20732 = 20.73%
20,500 20,500
Price in pesos 20.50
b. Purchase price = = $2.22584 × 1,000 shares = $2,225.84
Pesos per dollar 9.21
Price in pesos 24.75
Sales price = = $2.51269 × 1,000 shares = $2,512.69
Pesos per dollar 9.85
2,512.69 − 2,225.84 286.85
c. Returnpesos = = = 0.12887 = 12.89%
2,225.84 2,225.84
d. The two returns differ due to the change in the exchange rate between the peso and the dollar.
The peso had depreciation (and thus the dollar appreciated) between the purchase date and the
sale date, causing a decrease in total return. The answer in Part (c) is the more important of
the two returns for Joe. An investor in foreign securities will carry exchange-rate risk.

P5-15. LG 5: Total, nondiversifiable, and diversifiable risk

Intermediate
a. and b.

c. Only nondiversifiable risk is relevant because, as shown by the graph, diversifiable risk can
be virtually eliminated through holding a portfolio of at least 20 securities that are not positively
correlated. David Talbot’s portfolio, assuming diversifiable risk could no longer be reduced
by additions to the portfolio, has 6.47% relevant risk.
102 Gitman • Principles of Managerial Finance, Brief Fifth Edition

P5-16. LG 5: Graphic derivation of beta

Intermediate
a.

b. To estimate beta, the “rise over run” method can be used:

Rise ΔY
Beta = =
Run ΔX
Taking the points shown on the graph:
ΔY 12 − 9 3
Beta A = = = = 0.75
ΔX 8 − 4 4
ΔY 26 − 22 4
Beta B = = = = 1.33
ΔX 13 − 10 3
A financial calculator with statistical functions can be used to perform linear regression
analysis. The beta (slope) of Line A is 0.79; of Line B, 1.379.
c. With a higher beta of 1.33, Asset B is more risky. Its return will move 1.33 times for each one
point the market moves. Asset A’s return will move at a lower rate, as indicated by its beta
coefficient of 0.75.

P5-17. LG 5: Interpreting beta

Basic
Effect of change in market return on asset with beta of 1.20:
a. 1.20 × (15%) = 18.0% increase
b. 1.20 × (−8%) = 9.6% decrease
c. 1.20 × ( 0%) = no change
d. The asset is more risky than the market portfolio, which has a beta of 1. The higher beta
makes the return move more than the market.
 Chapter 5 Risk and Return 103

P5-18. LG 5: Betas
Basic
a. and b.

Increase in Expected Impact Decrease in Impact on

Asset Beta Market Return on Asset Return Market Return Asset Return
A 0.50 0.10 0.05 −0.10 −0.05
B 1.60 0.10 0.16 −0.10 −0.16
C −0.20 0.10 −0.02 −0.10 0.02
D 0.90 0.10 0.09 −0.10 −0.09

c. Asset B should be chosen because it will have the highest increase in return.
d. Asset C would be the appropriate choice because it is a defensive asset, moving in opposition
to the market. In an economic downturn, Asset C’s return is increasing.

P5-19. LG 5: Personal finance: Betas and risk rankings

Intermediate
a.

Stock Beta
Most risky B 1.40
A 0.80
Least risky C −0.30

b. and c.

Increase in Expected Impact Decrease in Impact on

Asset Beta Market Return on Asset Return Market Return Asset Return
A 0.80 0.12 0.096 −0.05 −0.04
B 1.40 0.12 0.168 −0.05 −0.07
C −0.30 0.12 −0.036 −0.05 0.015

d. In a declining market, an investor would choose the defensive stock, Stock C. While the
market declines, the return on C increases.
e. In a rising market, an investor would choose Stock B, the aggressive stock. As the market
rises one point, Stock B rises 1.40 points.
104 Gitman • Principles of Managerial Finance, Brief Fifth Edition

n
P5-20. LG 5: Portfolio betas: bp = ∑w
j =1
j × bj

Intermediate
a.
Portfolio A Portfolio B
Asset Beta wA wA × bA wB wB × bB
1 1.30 0.10 0.130 0.30 0.39
2 0.70 0.30 0.210 0.10 0.07
3 1.25 0.10 0.125 0.20 0.25
4 1.10 0.10 0.110 0.20 0.22
5 0.90 0.40 0.360 0.20 0.18
bA = 0.935 bB = 1.11

b. Portfolio A is slightly less risky than the market (average risk), while Portfolio B is more
risky than the market. Portfolio B’s return will move more than Portfolio A’s for a given
increase or decrease in market return. Portfolio B is the more risky.

P5-21. LG 6: Capital asset pricing model (CAPM): rj = RF + [bj × (rm − RF)]

Basic
Case rj = RF + [bj × (rm − RF)]
A 8.9% = 5% + [1.30 × (8% − 5%)]
B 12.5% = 8% + [0.90 × (13% − 8%)]
C 8.4% = 9% + [−0.20 × (12% − 9%)]
D 15.0% = 10% + [1.00 × (15% − 10%)]
E 8.4% = 6% + [0.60 × (10% − 6%)]

P5-22. LG 5, 6: Personal finance: Beta coefficients and the capital asset pricing model
Intermediate
To solve this problem you must take the CAPM and solve for beta. The resulting model is:
r − RF
Beta =
rm − RF
10% − 5% 5%
a. Beta = = = 0.4545
16% − 5% 11%
15% − 5% 10%
b. Beta = = = 0.9091
16% − 5% 11%
18% − 5% 13%
c. Beta = = = 1.1818
16% − 5% 11%
20% − 5% 15%
d. Beta = = = 1.3636
16% − 5% 11%
e. If Katherine is willing to take a maximum of average risk then she will be able to have an
expected return of only 16%. (r = 5% + 1.0(16% − 5%) = 16%.)
 Chapter 5 Risk and Return 105

P5-23. LG 6: Manipulating CAPM: rj = RF + [bj × (rm − RF)]

Intermediate
a. rj = 8% + [0.90 × (12% − 8%)]
rj = 11.6%
b. 15% = RF + [1.25 × (14% − RF)]
RF = 10%
c. 16% = 9% + [1.10 × (km − 9%)]
rm = 15.36%
d. 15% = 10% + [bj × (12.5% − 10%)
bj = 2

P5-24. LG 1, 3, 5, 6: Personal finance: Portfolio return and beta

Challenge
a. bp = (0.20)(0.80) + (0.35)(0.95) + (0.30)(1.50) + (0.15)(1.25)
= 0.16 + 0.3325 + 0.45 + 0.1875 = 1.13
($20,000 − $20,000) + $1,600 $1,600
b. rA = = = 8%
$20,000 $20,000
($36,000 − $35,000) + $1,400 $2,400
rB = = = 6.86%
$35,000 $35,000
($34,500 − $30,000) + 0 $4,500
rC = = = 15%
$30,000 $30,000
($16,500 − $15,000) + $375 $1,875
rD = = = 12.5%
$15,000 $15,000
($107,000 − $100,000) + $3,375 $10,375
c. rP = = = 10.375%
$100,000 $100,000
d. rA = 4% + [0.80 × (10% − 4%)] = 8.8%
rB = 4% + [0.95 × (10% − 4%)] = 9.7%
rC = 4% + [1.50 × (10% − 4%)] = 13.0%
rD = 4% + [1.25 × (10% − 4%)] = 11.5%
e. Of the four investments, only C (15% versus 13%) and D (12.5% versus 11.5%) had actual
returns that exceeded the CAPM expected return (15% versus 13%). The underperformance
could be due to any unsystematic factor that would have caused the firm not do as well as
expected. Another possibility is that the firm’s characteristics may have changed such that the
beta at the time of the purchase overstated the true value of beta that existed during that year.
A third explanation is that beta, as a single measure, may not capture all of the systematic
factors that cause the expected return. In other words, there is error in the beta estimate.
106 Gitman • Principles of Managerial Finance, Brief Fifth Edition

P5-25. LG 6: Security market line, SML

Intermediate
a. b. and d.

c. rj = RF + [bj × (rm − RF)]

Asset A
rj = 0.09 + [0.80 × (0.13 − 0.09)]
rj = 0.122
Asset B
rj = 0.09 + [1.30 × (0.13 − 0.09)]
rj = 0.142
d. Asset A has a smaller required return than Asset B because it is less risky, based on the beta
of 0.80 for Asset A versus 1.30 for Asset B. The market risk premium for Asset A is 3.2%
(12.2% − 9%), which is lower than Asset B’s market risk premium (14.2% − 9% = 5.2%).

P5-26. LG 6: Integrative-risk, return, and CAPM

Challenge
a.
Project rj = RF + [bj × (rm − RF)]
A rj = 9% + [1.5 × (14% − 9%)] = 16.5%
B rj = 9% + [0.75 × (14% − 9%)] = 12.75%
C rj = 9% + [2.0 × (14% − 9%)] = 19.0%
D rj = 9% + [0 × (14% − 9%)] = 9.0%
E rj = 9% + [(−0.5) × (14% − 9%)] = 6.5%
 Chapter 5 Risk and Return 107

b. and d.

c. Project A is 150% as responsive as the market.

Project B is 75% as responsive as the market.
Project C is twice as responsive as the market.
Project D is unaffected by market movement.
Project E is only half as responsive as the market, but moves in the opposite direction as the
market.

P5-27. Ethics problem

Intermediate
One way is to ask how the candidate would handle a hypothetical situation. One may gain insight
into the moral/ethical framework within which decisions are made. Another approach is to use a
pencil-and-paper honesty test—these are surprisingly accurate, despite the obvious notion that the
job candidate may attempt to game the exam by giving the “right” versus the individually accurate
responses. Before even administering the situational interview question or the test, ask the candidate
to list the preferred attributes of the type of company he or she aspires to work for, and see if
character and ethics terms emerge in the description. Some companies do credit history checks, after
gaining the candidates approval to do so. Using all four of these techniques allows one to “triangulate”
toward a valid and defensible appraisal of a candidate’s honesty and integrity.
108 Gitman • Principles of Managerial Finance, Brief Fifth Edition

„ Case
Analyzing Risk and Return on Chargers Products’ Investments
This case requires students to review and apply the concept of the risk–return tradeoff by analyzing two
possible asset investments using standard deviation, coefficient of variation, and CAPM.
( P − Pt −1 + Ct )
1. Expected rate of return: rt = t
Pt −1
Asset X:
Cash Ending Beginning Gain/ Annual Rate
Year Flow (Ct) Value (Pt) Value (Pt – 1) Loss of Return
2000 $1,000 $22,000 $20,000 $2,000 15.00%
2001 1,500 21,000 22,000 −1,000 2.27
2002 1,400 24,000 21,000 3,000 20.95
2003 1,700 22,000 24,000 −2,000 −1.25
2004 1,900 23,000 22,000 1,000 13.18
2005 1,600 26,000 23,000 3,000 20.00
2006 1,700 25,000 26,000 −1,000 2.69
2007 2,000 24,000 25,000 −1,000 4.00
2008 2,100 27,000 24,000 3,000 21.25
2009 2,200 30,000 27,000 3,000 19.26

Average expected return for Asset X = 11.74%

Asset Y:
Cash Ending Beginning Gain/ Annual Rate
Year Flow (Ct) Value (Pt) Value (Pt – 1) Loss of Return
2000 $1,500 $20,000 $20,000 $ 0 7.50%
2001 1,600 20,000 20,000 0 8.00
2002 1,700 21,000 20,000 1,000 13.50
2003 1,800 21,000 21,000 0 8.57
2004 1,900 22,000 21,000 1,000 13.81
2005 2,000 23,000 22,000 1,000 13.64
2006 2,100 23,000 23,000 0 9.13
2007 2,200 24,000 23,000 1,000 13.91
2008 2,300 25,000 24,000 1,000 13.75
2009 2,400 25,000 25,000 0 9.60

Average expected return for Asset Y = 11.14%

 Chapter 5 Risk and Return 109

n
2. σr = ∑ (r − r )
i =1
i
2
÷ (n − 1)

Asset X:
Return Average
Year ri Return, r ( ri − r ) ( ri − r ) 2
2000 15.00% 11.74% 3.26% 0.001063
2001 2.27 11.74 9.47 0.008968
2002 20.95 11.74 9.21 0.008482
2003 1.25 11.74 12.99 0.016874
2004 13.18 11.74 1.44 0.000207
2005 20.00 11.74 8.26 0.006823
2006 2.69 11.74 9.05 0.008190
2007 4.00 11.74 7.74 0.005991
2008 21.25 11.74 9.51 0.009044
2009 19.26 11.74 7.52 0.005655
0.071297

0.071297
σx = = 0.07922 = .0890 = 8.90%
10 − 1
8.90%
CV = = 0.76
11.74%

Asset Y:
Average
Year Return ri Return, r (ri − r ) (ri − r ) 2
2000 7.50% 11.14% −3.64% 0.001325
2001 8.00 11.14 −3.14 0.000986
2002 13.50 11.14 2.36 0.000557
2003 8.57 11.14 −2.57 0.000660
2004 13.81 11.14 2.67 0.000713
2005 13.64 11.14 2.50 0.000625
2006 9.13 11.14 −2.01 0.000404
2007 13.91 11.14 2.77 0.000767
2008 13.75 11.14 2.61 0.000681
2009 9.60 11.14 −1.54 0.000237
0.006955
110 Gitman • Principles of Managerial Finance, Brief Fifth Edition

0.006955
σY = = 0.0773 = 0.0278 = 2.78%
10 − 1
2.78%
CV = = 0.25
11.14%

3. Summary statistics:

Asset X Asset Y
Expected return 11.74% 11.14%
Standard deviation 8.90% 2.78%
Coefficient of variation 0.76 0.25

Comparing the expected returns calculated in Part (a), Asset X provides a return of 11.74%, only
slightly above the return of 11.14% expected from Asset Y. The higher standard deviation and
coefficient of variation of Investment X indicates greater risk. With just this information, it is difficult
to determine whether the 0.60% difference in return is adequate compensation for the difference in
risk. Based on this information, however, Asset Y appears to be the better choice.

4. Using the capital asset pricing model, the required return on each asset is as follows:
Capital asset pricing model: rj = RF + [bj× (rm − RF)]

Asset RF + [bj × (rm − RF)] = rj

X 7% + [1.6 × (10% − 7%)] = 11.8%
Y 7% + [1.1 × (10% − 7%)] = 10.3%

From the calculations in Part (a), the expected return for Asset X is 11.74%, compared to its required
return of 11.8%. On the other hand, Asset Y has an expected return of 11.14% and a required return
of only 10.8%. This makes Asset Y the better choice.

5. In Part c, we concluded that it would be difficult to make a choice between X and Y because the
additional return on X may or may not provide the needed compensation for the extra risk. In
Part (d), by calculating a required rate of return, it was easy to reject X and select Y. The required
return on Asset X is 11.8%, but its expected return (11.74%) is lower; therefore Asset X is
unattractive. For Asset Y the reverse is true, and it is a good investment vehicle.
Clearly, Charger Products is better off using the standard deviation and coefficient of variation, rather
than a strictly subjective approach, to assess investment risk. Beta and CAPM, however, provide a
link between risk and return. They quantify risk and convert it into a required return that can be
compared to the expected return to draw a definitive conclusion about investment acceptability.
Contrasting the conclusions in the responses to Questions c and d above should clearly demonstrate
why Junior is better off using beta to assess risk.
 Chapter 5 Risk and Return 111

6. a. Increase in risk-free rate to 8% and market return to 11%:

Asset RF + [bj × (rm − RF)] = rj

X 8% + [1.6 × (11% − 8%)] = 12.8%
Y 8% + [1.1 × (11% − 8%)] = 11.3%

b. Decrease in market return to 9%:

Asset RF + [bj × (rm − RF)] = rj
X 7% + [1.6 × (9% − 7%)] = 10.2%
Y 7% + [1.1 × (9% − 7%)] = 9.2%

In Situation 1, the required return rises for both assets, and neither has an expected return above the
firm’s required return.
With Situation 2, the drop in market rate causes the required return to decrease so that the expected
returns of both assets are above the required return. However, Asset Y provides a larger return
compared to its required return (11.14 − 9.20 = 1.94), and it does so with less risk than Asset X.

„ Spreadsheet Exercise
The answer to Chapter 5’s stock portfolio analysis spreadsheet problem is located in the Instructor’s
Resource Center at www.prenhall.com/irc.

„ A Note on Web Exercises

A series of chapter-relevant assignments requiring Internet access can be found at the book’s Companion
Website at http://www.prenhall.com/gitman. In the course of completing the assignments students access
information about a firm, its industry, and the macro economy, and conduct analyses consistent with those
found in each respective chapter.