Question:

RETURN AND RISK RELATIONSHIP: CAPITAL ASSET PRICING MODEL

The CFO of Baldwin Corporation, Jeff Warren has decided to invest some money in the financial market to diversify the risks of business operations and increase rate of return. He has been reading corporate finance books and journal articles to enhance his knowledge on risk/return relationships, capital asset pricing model (CAPM), cost of capital and valuation.

On risk/return relationship, Jeff has learnt that there is a positive relationship between risk and return. This implies that the higher the risk, the greater the expected return on an investment. This relationship is clearly explained by the capital asset pricing model in this equation:

RE = RF + ? x (RM - RF)

where RE = expected return of the security, RF = the risk-free rate, ? = Beta of the security, RM = the expected return on the market, and (RM - RF) represents the difference between the expected return on the market and the risk-free rate.

According to the CAPM, the expected return of any security depends on its risk measured by its beta. Jeff found out that thebeta is a measure of the risk of a security arising from exposure to general economic and market movements i.e., systematic risk as opposed to business specific risks or factors (i.e., unsystematic risk). The higher the beta, the greater the systematic risk and vice versa. The market portfolio of all investable assets has a beta of 1. Jeff learnt that If ? = 0, then the asset has no risk of financial loss. Therefore, the expected return of the security should be equal to the risk-free rate. If ? = 1, that asset has same risk as the market and the expected return should equal the expected return on the market such as the S&P 500 market index. To Jeff this makes sense because the beta of the market portfolio is exactly 1. However, if a security's ? = 2, then that security is twice riskier than the market and the expected return should be higher than the return of the market portfolio.

Jeff understands that the risk-free rate used in the CAPM is the government-issued treasury bill rate. Since the treasury bill has no risk, any other investment having some risk will have to have a higher rate of return than the risk-free rate in order to induce any investor to invest in that security. Jeff is considering the stock of Adobe Inc. and Exxon Mobil. Adobe Inc. has a beta of 1.6 and Exxon Mobil has a beta of 0.9. The risk-free rate is 3.5%, and the difference between the expected return on the market and the risk free is 9.0%.

Baldwin Inc. is retaining you as the financial consultant to work with Jeff to analyze these investment options.

1. Using the capital asset pricing model, calculate the expected return for Adobe Inc. and Exxon Mobil stocks.

2. You want to calculate the average return of Adobe Inc. to see how the stock has performed over the past five years:

Exhibit 1: Historical Returns of Adobe Inc.

Year Return

2015 15.30%

2016 26.20%

2017 33.12%

2018 2.90%

2019 -2.10%

a. Using the historical returns above, what is the average return for Adobe Inc. stock?

3. You notice that stock returns fluctuate daily in the financial market making it risky to invest in stocks. You want to use standard deviation, ?to assess the volatility of Adobe Inc. stock if mean return is 15.10% and standard deviation is 12%. What is the possible return of this stock one standard deviation from the mean if the return is normally distributed? (Note: expected return = mean return 1?).

4. You want to use total market return approachto estimate the rate of return on another stock which Jeff wants to consider for the investment portfolio. The stock is selling for $25 and pays a dividend of $2 per share during the year. You think that because of profitable capital investment that the company is undertaken, its stock price will appreciate to $35 per share by the end of next year.

a. Calculate the dividend yield.

b. Calculate the percentage capital gain of this stock.

c. What is the expected total return of this stock?

5. You are looking at sources of risk for the investment portfolio and came across systematic risk and unsystematic risk in a financial journal. The systematic risk is defined as any risk that affects the whole economy or large number of assets to a greater or lesser degree. And unsystematic risk is a risk that affects specific assets or small group of assets.

a. List two examples each of systematic risk and unsystematic risk.

6. Jeff wants you to estimate the weighted average cost of capital(WACC) for Verizon LLC. The IRR computed on a capital project for Verizon is 12%. Jeff wants to see if it will be a good investment. He thinks that if IRR > WACC then it will be a good investment to consider. The market values for Verizon's debt and equity are $40 million and $60 million respectively. The total value of the firm is $100 million, implying that the weight of debt is 40% ($40 million /$100 million) whereas the weight of equity is 60% ($60 million /$100 million).

a. Estimate WACC for Verizon if the cost of equity is 14.40% and after-tax cost of debt is 3.95%. (note: WACC = cost of debt (1 - tax rate) (weight Debt) + cost of equity (weight Equity).

Question 4 1 pts Suppose there are two types of people in a market where an insurance company is considering opening up. Both individuals have 3600 when health. They also have 1600 when sick. Their U(W)=1/W. Consider rst the Type A individuals. They get sick 10 percent of the time. What is their expected utility without insurance? Question 5 1 pts Continuing the problem from above, what is the most the type A individuals will pay for insurance? l _ Question 6 1 pts Now consider the Type B individuals. They get sick 40 percent of the time. What's the most they will pay for insurance? 9. According to statistics reported on news source, a surprising number of motor vehicles are not covered by insurance. Sample results, consistent with the news report, showed 50 of 200 vehicles were not covered by insurance. Question 30 3 pts 9 (a) What is the point estimate of the proportion of vehicles not covered by insurance? Question 31 3 pts 9 (b) Develop a 95% condence interval for the population proportion (Round your answer to four decimal places.) 0 0.1899 to 0.3100 O 0.1699 to 0.2900 O 0.1679 to 0.3000 O 0.1900 to 0.3300 QUESTION 27 allocate(s) a portion of the risk to another company in exchange for a portion of the premium. O Credit default swaps O Property insurance O Reinsurance O Casualty insurance QUESTION 28 The insures pension benefits up to a limit. O Pension Benefit Guarantee Corporation O FDIC O Employee Retirement Pension Corporation O SEC15. The Beef-Up Ranch feeds cattle for Midwestern farmers and delivers them to process ing plants in Topeka, Kansas, and Tulsa, Oklahoma. The ranch must determine the amounts of cattle feed to buy so that various nutritional requirements are met while minimizing total feed costs. The mixture fed to the cows must contain different levels of four key nutrients and can be made by blending three different feeds. The amount of each nutrient (in ounces) found in each pound of feed is summarized as follows: Nutrient (in ounces) per Pound of Feed Nutrient Feed 1 Feed 2 Feed 3 A B C D The cost per pound of feeds 1, 2, and 3 are $2.00, $2.50, and $3.00, respectively. The minimum requirement per cow each month is 4 pounds of nutrient A, 5 pounds of nutrient B, 1 pound of nutrient C, and 8 pounds of nutrient D. However, cows should not be fed more than twice the minimum requirement for any nutrient each month. (Note that there are 16 ounces in a pound.) Additionally, the ranch can only obtain 1,500 pounds of each type of feed each month. Because there are usually 100 cows at the Beef-Up Ranch at any given time, this means that no more than 15 pounds of each type of feed can be used per cow each month. a. Formulate a linear programming problem to determine how much of each type of feed a cow should be fed each month. b. Create a spreadsheet model for this problem, and solve it using Solver What is the optimal solution? open 40 hours