Risk & Return

(a) Returns for each stock in three economic state are summarized below:

An investor invested $100,000 in a portfolio with 60% invested in valued stock, 40% invested in growth stock. Calculate the expected return and standard deviation of the portfolio? Assume market efficiency and both stocks are correctly priced according to the CAPM. The risk-free rate is 3.5% and the market risk premium is 10 %. Which stock has the most systematic risk? Which one has the most unsystematic risk? Which stock is riskier? Explain.

(20 Marks)

(b) Novellus Inc. is a publicly traded company that operates in three businesses with the following characteristics:

The firm has 100 million shares trading at $ 12/share, has no cash balance and raises

the rest of its funding from debt. The marginal tax rate is 40%. i. Estimate the current levered beta for the firm. ii. Assume that Novellus is planning to sell its storage device business for the estimated value

and invest half the proceeds in its social media business and use the other half to retire

debt. Estimate the new beta for the firm. iii. How would you answer to ii change, if you used the proceeds entirely to buy back shares in the company

(c) A large conglomerate (multi-division company) is critiqued by one equity analyst about the companys focus on diversifying its business risk through investing aggressively in companies of many different business sectors. The analyst claimed that investors can achieve the diversification more efficiently by themselves.

Assess the rationale behind this statement based on the concept of diversification. (30 Marks)

(d) Why should a financial decision maker such as a corporate treasurer or CFO be concerned with market efficiency?

(20 Marks)

State of Economy Rate of Return if State Occurs Valued Stock Growth Stock Recession Normal Boom Probability of State of Economy 35% 40% 25% 6% 10% 18% -40% 19% 90% State of Economy Rate of Return if State Occurs Valued Stock Growth Stock Recession Normal Boom Probability of State of Economy 35% 40% 25% 6% 10% 18% -40% 19% 90%