Consider the following information for three stocks, Stocks X, Y, and Z. The returns on the three stocks are positively correlated, but they are not perfectly correlated. (That is, each of the correlation coefficients is between 0 and 1.)

Stock

Expected Return

Standard Deviation

Stock?s Beta Coefficient

X

9%

15%

0.8

Y

10.75

15

1.2

Z

12.5

15

1.6

Fund Q has one-third of its funds invested in each of the three stocks. The risk-free rate is 5.5%, and the market is in equilibrium. (That is, required returns equal expected returns.)

a) What is the market risk premium?

b) What is the beta of Fund Q?

c) What is the expected return of Fund Q?

d) Would you expect the standard deviation of Fund Q to be less than 15%, equal to 15%, or greater than 15%? Explain.

Advanced Financial Management Assignment for Chapter I: Submission Date: April 16, 2016 G.C. Rift Valley University Department of Accounting and Finance Post Graduate Program: Bole Campus Advanced Financial Management CHAPTER ASSIGNMENT CHAPTER ONE: RISK MANAGEMENT AND LEVERAGE ANALYSIS Instruction: Show all the necessary steps neatly in responding each of the questions presented hereunder! Last Date of Submission: Saturday April 16, 2016 in the class only 1. Stocks X and Y have the following probability distributions of expected future returns: Probability X 0.1 - 10% 0.2 2 0.4 12 0.2 20 0.1 38 a) Calculate the expected rate of return, for each Stock. Y - 35% 0 20 25 45 b) Calculate the standard deviation of expected returns, , for Stock X and Y c) Calculate the coefficient of variation for Stock Y. d) Is it possible that most investors will regard Stock Y as being less risky than Stock X? Explain. 2. Consider the following information for three stocks, Stocks X, Y, and Z. The returns on the three stocks are positively correlated, but they are not perfectly correlated. (That is, each of the correlation coefficients is between 0 and 1.) Stock Expected Standard Stock's Beta Return Deviation Coefficient X 9% 15% 0.8 Y 10.75 15 1.2 Z 12.5 15 1.6 Fund Q has one-third of its funds invested in each of the three stocks. The risk-free rate is 5.5%, and the market is in equilibrium. (That is, required returns equal expected returns.) a) What is the market risk premium? b) What is the beta of Fund Q? c) What is the expected return of Fund Q? d) Would you expect the standard deviation of Fund Q to be less than 15%, equal to 15%, or greater than 15%? Explain. Page 1 of 3 Advanced Financial Management Assignment for Chapter I: Submission Date: April 16, 2016 G.C. 3. Stock X has a 10% expected return, a beta coefficient of 0.9, and a 35% standard deviation of expected returns. Stock Y has a 12.5% expected return, a beta coefficient of 1.2, and a 25% standard deviation. The risk-free rate is 6%, and the market risk premium is 5%. a) Calculate each stock's coefficient of variation. b) Which stock is riskier for a diversified investor? c) Calculate each stock's required rate of return. d) On the basis of the two stocks' expected and required returns, which stock would be more attractive to a diversified investor? e) Calculate the required return of a portfolio that has Br. 7,500 invested in Stock X and Br. 2,500 invested in Stock Y. f) If the market risk premium increased to 6%, which of the two stocks would have the larger increase in its required return? 4. You plan to invest in the Kassa Hedge Fund (a portfolio of stocks built by raising the capital from various investors through a hedge fund company), which has total capital of Br. 500 million invested in five stocks: Stock Investment Stock's Beta Coefficient A Br. 160,000,000 0.5 B 120,000,000 1.2 C 80,000,000 1.8 D 80,000,000 1.0 E 60,000,000 1.6 Kassa's beta coefficient can be found as a weighted average of its stocks' betas. The risk-free rate is 6%, and you believe the following probability distribution for future market returns is realistic: Probability Market Return 0.1 - 28% 0.2 0 0.4 12 0.2 30 0.1 50 a) What is the equation for the Security Market Line (SML)? (Hint: First, determine the expected market return.) b) Calculate Kassa's required rate of return. Page 2 of 3 Advanced Financial Management Assignment for Chapter I: Submission Date: April 16, 2016 G.C. c) Suppose Kassa Bedru, the president, receives a proposal from a company seeking new capital. The amount needed to take a position in the stock is Br. 50 million, it has an expected return of 15%, and its estimated beta is 1.5. Should Kassa invest in the new company? At what expected rate of return should Kassa be indifferent to purchasing the stock? 5. David Dingo Basketball Club currently has Br. 3 million in debt outstanding, bearing an interest rate of 12%. It wishes to finance a Br. 4 million expansion program and is considering three alternatives: additional debt at 14% interest (option 1), preferred stock with a 12% dividend (option 2), and the sale of common stock at Br. 16 per share (option 3). The company currently has 800,000 shares of common stock outstanding and is in a 40% tax bracket. a) If earnings before interest and taxes are currently Br. 1.5 million, what would be earnings per share for the three alternatives, assuming no immediate increase in operating profit? b) Develop a break-even, or indifference, chart for these alternatives. What are the approximate indifference points? To check one of these points, mathematically determine the indifference point between the debt plan and the common stock plan. What are the horizontal axis intercepts? c) Compute the degree of financial leverage (DFL) for each alternative at the expected EBIT level of Br. 1.5 million. d) Which alternative do you prefer? How much would EBIT need to increase before the next alternative would be \"better\" (in terms of EPS)? Page 3 of 3