Case assignment 3 on Risk & Return

Don Kraska, CFA, is preparing to answer a list of questions concerning stock valuation. These questions and answers were to serve as the outline for a presentation before a committee of officials from the Town of Webley. The committee needed advice on how best to follow the instructions in the will of James Lawrence, who had left the town 2,000 shares of Google stock, currently valued at approximately $1,250,000. Lawrences will instructed the town to sell the Google shares and set up a diversified stock portfolio that would fund annual grants for youth groups in the town. During the course of Kraskas first presentation, Webley officials expressed a great deal of concern about the risks of the stock market, yet Lawrences instructions were quite clear. The town was to invest the money in stocks, not bonds or certificates of deposit, and it could retain only limited amounts of cash for grant-making purposes.

Kraska has set up a second meeting to discuss risk. He really wants this account, so he will try to

strike the right tone and behave reassuringly, but still be realistic. He has been in the business since 1985, so he knows very well that the market has its ups and downs. Assume once again that you are Kraska preparing to answer a set of return- and risk-oriented questions that have surfaced as a result of the first presentation.

Questions

1. How do we measure the returns on our portfolio? Assuming that a $1,000,000 portfolio in a given year earns $30,000 in dividends and either gains or loses $100,000 in market value. Show his computations. Be prepared to answer a follow-up question about the value of the portfolio after a 5% grant distribution. Kraska will also compute Lawrences EAR on his investment in Google to illustrate a multiyear perspective. Lawrence purchased the Google stock for $200,000 and held it for three years before he died.
2. How can we assess the risk of an individual stock? a) Assuming that Kraska wish to first address this question by looking at recent returns on Amazon.com and on Coca- Cola. Compute the mean and standard deviation for each, and explain their meaning. He has collected the following return data:

Table 1.0

Year	Amazon.com	Coca-Cola
2007	134.77%	33.35%
2006	-16.31%	26.35%
2005	6.46%	2.24%
2004	-15.83%	13.93%
2003	178.56%	21.94%

b) Kraska will also suggest that it is good to assess risk by looking forward to how we expect stocks

to react to a particular set of circumstances or state of nature. Use the following set of

assumptions for the coming year to compute the

expected rate of return and the standard deviation for Amazon.com, Coca-Cola, and a portfolio

with equal dollar amounts invested in Amazon.com and Coca-Cola (use Table 2).

Table 2

State of Nature	Probability	Amazon.com Return	Coca-Cola Return	50/50 Portfolio Return
Recession	30%	-25%	5%	-10.00%
Average	50%	30%	12%	21%
Boom	20%	50%	20%	32.4%

3. What kinds of investments are safe and earn a high rate of return?

4. Google seems to be a great company. Why did Lawrence require the town to sell the Google stocks and reinvest the money in a diversified portfolio?

5. How many stocks should we have in our portfolio?

6. How much risk will the portfolio carry?

a. Kraska will answer this question by explaining the capital asset pricing model in the most

straightforward terms possible.

b. He will illustrate how we use the CAPM to compute the expected rate of return on a stock. Use an expected market return of 12%, a risk-free rate of 5%, and the betas for Amazon.com (3.02), Coca-Cola (0.62), and Merck Pharmaceuticals (1.11) to compute the expected rate of return on these stocks.

c. He will illustrate the concept of portfolio beta using the same three stocks. Compute the beta

for a portfolio composed of $20,000 invested in Amazon.com, $50,000 in Coca-Cola, and $35,000 in Merck Pharmaceuticals.