You recently graduated from college and your job search led you to S&S Air. Because you felt the companys business was taking off, you accepted a job offer. The first day on the job, while you are finishing your employment paperwork, Chris Guthrie, who works in Finance, stops by to inform you about the companys 401(K) plan.

A 401(K) plan is a retirement plan offered by many companies. Such plans are tax-deferred savings vehicles, meaning that any deposits you make into the plan are deducted from your current pretax income, so no current taxes are paid on the money. For example, assume your salary will be $50,00 per year. If you contribute $3,000 to the 401(K) plan, you will pay taxes on only $47,000 in income. There are also no taxes paid on any capital gains or income while you are invested in the plan, but youd pay taxes when you withdraw money at retirement. As is fairly common, the company also has a 5 percent match. This means that the company will match your contribution up to 5 percent of your salary, but you must contribute to get the match.

The 401(K) plan has several options for investments, most of which are mutual funds. A mutual fund is a portfolio of assets. When you purchase shares in a mutual fund, you are actually purchasing partial ownership of the funds assets. The return of the fund is the weighted average of the return of the assets owned by the fund, minus any expenses. The largest expense is typically the management fee, paid to the fund manager. The management fee is compensation for the manager, who makes all of the investment decisions for the fund.

S&S Air uses Bledsoe Financial Services as its 401(K)-plan administrator. Here are the investment options offered for employees:

Company Stock One option in the 401(K) plan is stock in S&S Air. The company is currently privately held. However, when you interviewed with the owners, Mark Sexton and Todd Story, they informed you the company stock was expected to go public in the next three to four years. Until then, a company stock price is simply set each year by the board of directors.

Bledsoe S&P 500 Index Fund This mutual fund tracks the S&P 500. Stocks in the fund are weighted exactly the same as the S&P 500. This means the fund return is approximately the return on the S&P 500, minus expenses. Because an index fund purchases assets based on the composition of the index it is following, the fund manager is not required to research stocks and make investment decisions. The result is that the fund expenses are usually low. The Bledsoe S&P 500 Index Fund charges expenses of .15 percent of assets per year.

Bledsoe Small-Cap Fund This fund primarily invests in small-capitalization stocks. As such, the returns of the fund are more volatile. The fund can also invest 10 percent of its assets in companies based outside the United States. This fund charges 1.70 percent in expenses.

Bledsoe Large-Company Stock Fund This fund invests primarily in large-capitalization stocks of companies based in the United States. The fund is managed by Evan Bledsoe and his outperformed the market in six of the last eight years. The fund charges 1.50 percent in expenses.

Bledsoe Money Market Fund This fund invests in sort-term, high credit-quality debt instruments, which include Treasury bills. As such, the return on the money market fund is only slightly higher than the return on Treasury bills. Because of the credit quality and short-term nature of the investments, there is only a very slight risk of a negative return. The fund charges .60 percent in expenses.

Question

A measure of risk-adjusted performance that is often used is the Sharpe ratio. The Sharpe ratio is calculated as the risk premium of an asset divided by its standard deviation. The standard deviation and return of the funds over the past 10 years listed in the following table. Calculate the Sharpe ratio for each of these funds. Assume that the expected return and standard deviation of the company stock will be 18 percent and 70 percent, respectively. Calculate the Sharpe ratio for the company stock. How appropriate is the Sharpe ratio for these assets? When would you use the Sharpe ratio?

10 Year Annual Return Standard Deviation

Bledsoe S&P 500 Index Fund 11.48% 15.82%

Bledsoe Small-Cap Fund 16.68 19.64

Bledsoe Large-Company Stock Fund 11.85 15.41

Bledsoe Bond Fund 9.67 10.83