You hold a diversified portfolio of stocks and are considering investing in the XYZ Company. The firms prospects look good and you estimate the following probability distribution of possible returns:

Probability Return

70% 15%

20% 9%

10% 20%

The return on the market is 13.5% and the risk free rate is 7%. You have calculated XYZs beta from past returns as 1.3 and you believe this will be the future beta.

1. What is the expected return for XYZ?

2. Why is the standard deviation of possible returns for XYZ not an important statistic in this situation?

3. What is the required return for XYZ according to the CAPM?

4. Based on your calculations in the three questions above, should you buy stock in XYZ Company? Why or why not?

5. Distinguish between business risk and financial risk.

6. Compare diversifiable and non-diversifiable risk. What are some examples of each type of risk?