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PFM15e IM CH08 - FM Course

Performance Management System and Feedback (Indian Institute of Management–

Amritsar)

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Part 4
Risk and the Required Rate of Return

Chapters in this Part

Chapter 8 Risk and Return
Chapter 9 The Cost of Capital

Integrative Case 4: Eco Plastics Company

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Chapter 8
Risk and Return

 Instructor’s Resources

Chapter Overview
This chapter focuses on the fundamentals of risk and return—beginning with simple definitions of total and
expected return, risk neutral, risk averse, and risk seeking. The discussion then moves to risk measurement by
focusing on a single asset and measuring risk with statistics associated with a probability distribution—
namely, mean, standard deviation, and coefficient of variation. To demonstrate that insights about risk for a
single asset do not necessarily carry through to a collection of assets, the discussion broadens to risk and
return for a portfolio. Diversification is introduced through examination of risk for a portfolio of positively
correlated, negatively correlated, and uncorrelated assets. The key takeaway is that the volatility (risk) of a
portfolio will be less than a weighted average of the volatilities of the assets in the portfolio as long as the
correlation is less than 1.0. The potential for risk-reduction through international diversification is offered as an
intuitive example. These ideas are used to motivate the Capital Asset Pricing Model (CAPM). Diversifiable
and nondiversifiable risk are distinguished, with the key idea that the market only rewards bearing
nondiversifiable risk because firm-specific risk can so easily be eliminated through diversification. Then, the
CAPM equation and its pictorial representation (Security Market Line or SML) are introduced to show the
link between return and nondiversifiable risk. The chapter concludes by illustrating the impact of changes in
inflation expectations and investor risk aversion on the SML.

 Suggested Answer to Opener-in-Review

You learned Bill Miller’s investment performance ranged from the very bottom to the very top of his
profession, thereby suggesting his fund took more risk than other mutual funds. The table below shows the
2009 to 2012 annual returns for Miller’s Opportunity fund and the S&P 500 index.

Year Opportunity Fund S&P 500

2009 76.0% 26.5%
2010 16.6% 15.1%
2011 –34.9% 2.11%
2012 39.6% 16.0%
Calculate average annual return for the Opportunity fund and S&P 500. Which performed better over this
period? If you had invested $1,000 in each fund January 1, 2009, how much money would you have had at
the end of 2012? Calculate the standard deviations of returns for the two funds. Which was more volatile?
Average annual return on Opportunity = (76.0% + 16.6% − 34.9% + 39.6%) ÷ 4 = 97.30% ÷ 4 = 24.33%.
Average annual return on S & P 500 = (26.5% + 15.1% + 2.11% + 16.0%) ÷ 4 = 59.71% ÷ 4 = 14.93%.

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The Opportunity Fund performed better. A $1,000 investment in Opportunity January 1, 2009 would have
grown to $1,865 by year-end 2012 ($1,000 × 1.76 × 1.166 × 0.651 × 1.396) while a $1,000 investment in
the S&P 500 would have grown to only $1,724 ($1,000 × 1.265 × 1.151 × 1.0211 × 1.160).
To find standard deviation of returns (σ) for each fund, use the standard-deviation formula for n
observations of that fund’s historical data:

, where rj is return in year j (running to year n) and is average return over n years.
For the Opportunity Fund:
Opportunity
Fund Mean Difference
Year Return Return Difference Squared
2009 76.00% 24.33% 0.51675 0.26703
2010 16.60% 24.33% -0.07725 0.00597
2011 -34.90% 24.33% -0.59225 0.35076
2012 39.60% 24.33% 0.15275 0.02333
Sum of Squared Differences = 0.64709
n-1= 3
Sum of Squared Differences / (n - 1) = 0.215696917
Square Root of Sum of Squared Differences / (n - 1) = 46.44%

For the S&P 500:

Opener

Opportunity S&P 500

Year Fund
2009 76.00% 26.50%
2010 16.60% 15.10%
2011 -34.90% 2.11%
2012 39.60% 16.00%
97.30% 59.71%
Mean = 24.33% 14.93%
Std. Dev. 46.4% 10.0%
Note: The Excel command for standard deviation is STDEV. If historical returns for one of the funds
above appeared in rows 1-4 of column A of a worksheet, proper syntax would be: =stdev(A1:A4)
Miller’s fund, Opportunity, was the more volatile because its standard deviation of returns was 4.65 times
higher the standard deviation of S&P 500 returns.

 Answers to Review Questions

8-1. Risk refers to the uncertainty about the return an investment will earn.

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Chapter 8 Risk and Return 5

8-2 Total return (gain or loss) on an investment over a given time period is the change in value over that
period plus any cash distributions, expressed as a percentage of beginning-of- period value.
Specifically:

8-3 a. Risk-averse investors dislike risk and, therefore, expect higher returns on riskier investments.
b. Risk-neutral investors select investments based on expected return—the higher the better—without
regard to risk. Such investors require no compensation for bearing more risk.
c. Risk-seekers like risk. Just as risk-averse investors will give up some return to avoid some risk,
risk-seeking investors will give up some return to take more risk.
Most financial managers are risk averse—they expect compensation for bearing additional risk. Risk
tolerance refers an investor’s degree of risk aversion, that is the specific compensation she requires for
taking additional risk. Two investors may both refuse to accept more risk unless awarded a higher
expected return—that is, both are risk averse. But the more risk tolerant of the two will require less
additional compensation.

8-4. Scenario analysis assesses asset risk using more than one possible set of returns to gauge the variability
of outcomes. Range—a measure of variability—is found by subtracting the pessimistic outcome from
the optimistic outcome, with larger ranges suggesting greater risk. Note, however, after getting deeper
into the chapter, students will learn the range of outcomes suffers as a risk measure by not
distinguishing diversifiable and undiversifiable components.

8-5 Decision makers can estimate risk with a plot of the probability distribution—which relates probabilities
to potential returns by showing the dispersion in returns. The wider the distribution of potential returns,
the greater the variability (risk) associated with returns. It is important to note, however, the plot offers
a feel for an asset’s risk but does not distinguish between diversifiable and undiversifiable components.

8-6. The standard deviation of a distribution of asset returns is an absolute measure of dispersion of risk
around the mean or expected value. A higher standard deviation more variable returns.

8-7 The coefficient of variation (CV)—another risk indicator—is the standard deviation on an asset’s
returns divided by its average return. In other words, rather than measuring risk solely by the volatility
of an asset’s returns, CV shows the volatility of returns relative to average or expected return.

8-8 An efficient portfolio offers the maximum return for a given risk level. Portfolio return is just the
weighted average of returns on individual assets in the portfolio. Specifically:
n
rp = (w1×r1) + (w2×r2) + … + (wn×rn) = ∑ ( w j × r j )
j=1

where:
rp = portfolio return rj = the return on asset j

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6 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

n
wj = the portfolio weight of asset j (∑ w j = 1) n = number of assets in the portfolio
j=1

The standard deviation of a portfolio is not the weighted average of the standard deviations of
component assets. Rather, it is calculated with the standard-deviation formula, using portfolio returns
for various time periods (rather than returns on individual assets in the portfolio) and the average
portfolio return over those time periods. Specifically:

√∑
2
σrp =
n
( r i−r̅ p ) where: σrp = standard deviation of portfolio returns
j=1 ( n−1 )

8-9 The correlation between asset returns is key to evaluating the effect of a new asset on portfolio risk.
Returns on different assets that move in the same direction are positively correlated, while those
moving in opposite directions are negatively correlated. Unless the returns on assets in a portfolio are
perfectly positively correlated, portfolio standard deviation will be less than the weighted average of
the standard deviations of portfolio assets. If the absolute value of correlation between assets in the
portfolio is sufficiently low—it need not be negative—portfolio standard deviation may be less than the
standard deviation of the least volatile portfolio asset. In short, the magic of diversification is that
portfolio returns can be less volatile than the returns on any single portfolio asset.

8-10 Adding foreign assets to a domestic portfolio can reduce risk for the same reason a portfolio of two
domestic assets can have less risk than one asset: returns on foreign investments are not perfectly
correlated with returns on U.S. investments, so an internationally diversified portfolio generally has a
lower standard deviation of returns (less risk) than a purely domestic portfolio. That said, under some
circumstances, international diversification can produce subpar returns. For example, when the dollar
appreciates relative to other currencies, the dollar value of foreign-currency-denominated portfolios
declines, thereby producing lower dollar returns. If the appreciation is traceable to a strong U.S.
economy, foreign-currency-denominated portfolios will generally have lower returns in local currency
as well, further reducing returns. Political risk—the risk political instability or hostile governments
could endanger foreign assets or profits—is another potential pitfall of international diversification,
particularly when investing in developing countries.

8-11 The total risk of a security is measured by the standard deviation of returns; it has two components –
nondiversifiable risk and diversifiable risk. Diversifiable risk refers to the portion of risk attributable to
firm-specific, random events (such as strikes, litigation, and loss of key contracts) that can be
eliminated by diversification. Nondiversifiable risk, in contrast, is attributable to market factors
affecting all firms at the same time (such as war, inflation, and political events). Nondiversifiable risk
is the only relevant risk because diversifiable risk can be easily eliminated by forming a portfolio of
assets with less than perfect positive correlation. Because investors can easily eliminate this risk, the
market will not offer compensation in the form of higher returns to those who bear it.

8-12 Beta measures the nondiversifiable risk of a specific asset or portfolio; it is an index of the co-
movement of an asset’s return with the market return. The beta coefficient for an asset can be found by
plotting the asset’s historical returns relative to the returns for the market and using statistical

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Chapter 8 Risk and Return 7

techniques to fit the “characteristic line” to the data points. The slope of this line is beta. Beta
coefficients for actively traded stocks are widely published in print and online. The beta of a portfolio
is simply the weighted average of the betas of component assets.

8-13 The capital asset pricing model (CAPM) is given by:

rj  RF [βj(rm  RF)]
where:
rj  required (or expected) return on asset j

RF rate of return required on a risk-free security (U.S. Treasury bill)

βj beta coefficient or index of nondiversifiable (relevant) risk for asset j

rm  required return on market portfolio of assets (market return)

The security market line (SML) is a pictorial presentation of the relationship between an asset’s
systematic risk and the required return. Systematic risk—measured by beta—is on the horizontal axis
while required return is on the vertical axis.

8-14 a. An increase in inflationary expectations shifts the SML upwards by an amount equal to the
increase. The shift is parallel—that is, SML slope remains the same—because the only change is
that required return for a given level of risk rose to reflect the higher expected inflation rate.
b. If investors become less risk averse, the slope of the SML (beta coefficient) will decline—that is
the SML will rotate clockwise around the given fixed risk-free rate because a lower return is now
required for each level of risk.

 Suggested Answer to Global Focus Box:

“An International Flavor to Risk Reduction”
International mutual funds do not include any domestic assets, whereas global mutual funds include both
foreign and domestic assets. How might this difference affect their correlation with U.S. equity mutual funds?

Global funds differ from international funds by investing in stocks and bonds around the world, including
U.S. securities. International funds, in contrast, invest in stocks and bonds around the world but not U.S
securities. Global funds, therefore, are more likely to be correlated with U.S. mutual funds because U.S.
securities (particularly equities) are typically a sizeable chunk of their portfolios. A U.S. investor seeking to
further internationally diversify her portfolio should either add international funds or—if the portfolio already
includes global funds—increase the portfolio weight of those funds.

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8 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

 Suggested Answer to Focus on Ethics Box:

“If It Sounds Too Good to Be True, It Probably Is”
What are warning signs an investment advisor’s activities may be suspect? Both Ponzi and Madoff claimed
later they knew what they were doing was wrong, but they expected to earn enough eventually to deliver on
their promises. Do you believe them?

Academic research on the investment performance of actively managed funds has produced two consistent
findings: (i) after adjusting for differences in fees, active funds do not—on average—outperform passive
(index) funds, and (ii) funds that do outperform the market for a while cannot maintain that edge. These
findings suggest a fund manager can consistently beat the market over a long period only by taking more risk
or committing fraud. (And, “taking more risk” in this context means returns will be more volatile than the
market return.) So investors should beware of fund managers who claim to earn “abnormal” returns
consistently over a long stretch, particularly if the explanation offered is a new, proprietary strategy. As for
believing Ponzi and Madoff, of course, it is impossible to know what was in their hearts. But successful scam
artists have to be good salesman, and all good salesman must—to some extent at least—believe their pitch.
That is what makes the pitch so believable to others (along with greed). The bottom line here is that scam
artists seldom wear nametags identifying themselves as such. So it is best to look past the sales pitch and ask
skeptical questions about returns that appear too good to be true.

 Answers to Warm-Up Exercises

E8-1 Total annual return (LG 1)

Answer: Total return is given by: where:

rt = actual rate of return during period t Pt = price (value) of asset at time t
Ct = cash (flow) received asset in period t Pt – 1 = price (value) of asset at time t – 1
Mallard paid no dividend during the year. Market capitalization was $20 million at the beginning
of the year and $23 million at the end. So total return is:
($0 + $23,000,000 – $20,000,000) ÷ $20,000,000 = 0.15 or 15%
The actual return of Mallard is much higher than what was estimated by the analyst. The loss
reported during the year is irrelevant for shareholder return.

E8-2 Expected return (LG 2)

Answer: Expected return on Flourine Chemical stock is the weighted-average return, meaning each
analyst’s prediction is weighted by the probability assigned; then weighted values are summed.
Specifically:
Analyst Probability Return Weighted Value

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Chapter 8 Risk and Return 9

1 0.35 7%
2 0.35 5% 
3 0.05 -4%
4 0.25 10%
Total = 1.00 Expected return

E8-3 Comparing the risk of two investments (LG 2)

Answer: The coefficient of variation is given by: where:

σ = standard deviation of returns on the investment r = average return on the investment.

Investment 1 has a standard deviation of 10% and an average return of 15% while Investment 2
has a standard deviation of 5% and an average return of 12%, so:
CV1  0.10  0.15  0.6667 CV2  0.05  0.12  0.4167
Based on standard deviations and coefficients of variation, Investment 2 has lower risk if held in
isolation. That said, neither standard deviation nor coefficient of variation decomposes measured
volatility into nondiversifiable and diversifiable components. But coefficient of variation does at
least measure an asset’s volatility relative to expected return and, therefore, offers a broader
perspective on risk than standard deviation alone.

E8-4 Computing the expected return of a portfolio (LG 3)

Answer: The expected return on the portfolio is the weighted-average of the expected returns on portfolio
components. Put another way, the expected return on each asset is weighted by its percentage of
the portfolio and then the weighted values are summed. Specifically:

rp = (0.25 × 0.048) + (0.5 × 0.152) + (0.25 × 0.234) = 0.012 + 0.076 + 0.0585 = 0.1465 =
14.65%

The portfolio is expected to have a return of approximately 14.7%.

E8-5 Calculating a portfolio beta (LG 5)

Answer: Portfolio beta is just the weighted average of betas of individual portfolio components, meaning
the beta on each asset is weighted by its share of the portfolio and weighted betas summed.
Specifically:
Beta  (0.20  1.15)  (0.10  0.85)  (0.15  1.60)  (0.20  1.35)  (0.35  1.85)
 0.2300  0.0850  0.2400  0.2700  0.6475  1.4725

E8-6 Calculating the required rate of return (LG 6)

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10 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

Answer: The CAPM equation can be used to find required return, given an asset’s beta, the risk-free rate,
and market return. Specifically:

where:
rj = required return on asset j β j = Beta coefficient for asset j
RF = risk-free rate rm = Expected return on market portfolio of assets
a. Required return  0.05  1.8 (0.10  0.05)  0.05  0.09  0.14.
b. Required return  0.05  1.8 (0.13  0.05)  0.05  0.144  0.194.
c. The risk-free rate does not change, but market return increases. The resulting rise in the
market-risk premium will cause the Security Market Line (SML) to rotate counterclockwise
about the fixed risk-free rate..

 Solutions to Problems
P8-1 Rate of return (LG 1; Basic)
Total return on an investment is given by:

where: rt = total return on asset Pt = Price of asset at time t-1

Pt = Price of asset at time t Ct = Cash received between t-1 and t
71,000−63,000+6,100
a. Investment A: Return ¿ =22.38%
63,000
32,000−35,000+2,800
Investment B: Return ¿ =−0.57 %
35,000

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Chapter 8 Risk and Return 11

b. Investment A should be selected because it has a higher rate of return for the same level of risk.

P8-2 Return calculations (LG 1; Basic)

Total return on an investment is given by:

where: rt = total return on asset Pt = Price of asset at time t-1

Pt = Price of asset at time t Ct = Cash received between t-1 and t
Investment Calculation rt (%)

A ($20,100 − $23,400 − $2,800)  $23,400 –26.07

B ($324,000 − $225,000 + $16,000)  $225,000 51.11

C ($8,000 − $6,500 + $700)  $6,500 33.85

D ($46,500 − $36,600 + $3,580)  $36,600 36.83

E ($52,800 − $62,700 + $500)  $62,700 –16.59

P8-3 Risk preferences (LG 1; Intermediate)

a. The risk-neutral manager would accept Investments A and B because these have higher returns
than the 15% required return, and the risk does not matter.
b. The risk-averse manager would accept Investment A because it provides the highest return and
has the lowest amount of risk. Investment A offers an increase in return for taking on more risk
than what the firm currently bears.
c. The risk-seeking manager would accept Investments B and C because he or she is willing to take
on greater risk without an increase in return.
d. Traditionally, financial managers are risk averse and would choose Investment A, since it
provides the required increase in return for an increase in risk.

P8-4 Risk analysis (LG 2; Intermediate)

a. Range is the difference between the return with the best outcome and the return with the worst.

Project A = 25% – 12% = 13%

Project B = 40% – 8% = 32%
b. Project A seems to be less risky as the range of returns for this project is much smaller than what
it is for Project B.
c. Although Project B has a higher expected return, it also has higher dispersion of possible returns
and hence higher risk. A, in contrast, has a lower expected return but also lower risk. So the
choice of project depends upon the risk preference of the firm, in addition to any other
qualitative or strategic reasons.

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12 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

d. The answer will still be not very clear, as the facts remain the same and the basic choice is the
risk return tradeoff which will be decided by the risk preference of the management.

P8-5 Risk and probability (LG 2; Intermediate)

a. Range is the difference between return with the best outcome and return with the worst.

Camera Range
R 30%  20%  10%
S 35%  15% 20%

b. Possible Probability Expected Return Weighted Value (%)

Camera Outcomes Pri ri (ri  Pri)
Pessimistic 0.25 20 5.00%
R Most likely 0.50 25 12.50%
Optimistic 0.25 30 7.50%
1.00 Expected return = 25.00%
Pessimistic 0.20 15 3.00%
S Most likely 0.55 25 13.75%
Optimistic 0.25 35 8.75%
1.00 Expected return = 25.50%
c. Camera S is riskier than Camera R because it has a broader range of outcomes. Note the risk-
return tradeoff because Camera S has more risk but also provides a higher return.

P8-6 Bar charts and risk (LG 2; Intermediate)

a.

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Chapter 8 Risk and Return 13

b. Jeans Market Probability Expected Return Weighted Value

Line Acceptance Pri ri (ri  Pri)
Very Poor 0.05 0.0075 0.000375
Poor 0.15 0.0125 0.001875
J Average 0.60 0.0850 0.051000
Good 0.15 0.1475 0.022125
Excellent 0.05 0.1625 0.008125
1.00 Expected return = 0.083500
Very Poor 0.05 0.010 0.000500
Poor 0.15 0.025 0.003750
K Average 0.60 0.080 0.048000
Good 0.15 0.135 0.020250
Excellent 0.05 0.150 0.007500
1.00 Expected return = 0.080000

c. Line K appears less risky because of a slightly tighter distribution of potential outcomes.

P8-7 Coefficient of variation (LG 2; Basic)

Coefficient of variation is given by : ,

where σ r is the standard deviation of returns, and r is expected return
a. The coefficients of variation for projects A, B, C, and D are:
CVA = 6.5  18= 0.3611
CVB = 11.2  22 = 0.5090
CVC = 5.0  15 = 0.3333
CVD = 3.5  12 = 0.2916
b. Project D has the lowest coefficient of variation, and hence this indicates relatively low risk.

P8-8 Standard deviation versus coefficient of variation as measures of risk (LG 2; Basic)
a. Project A is least risky based on range because it has the smallest value (4%).
b. Project A has the lowest standard deviation. Standard deviation fails to take into account both the
volatility and return of the investment and does not distinguish between a project’s diversifiable
and nondiversifiable risk.

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14 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

c. Coefficient of variation is given by : ,

σ
where r is the standard deviation of returns and r is expected return. The coefficients of
variation for projects A, B, C, and D are:

A: C:

B: D:
Project D may be the best alternative because it has the least amount of risk per percentage point
of return. Coefficient of variation is probably the best measure here because it provides a
standardized method of capturing the risk-return tradeoff for investments with differing returns.
That said, like the standard deviation, the coefficient of variation does not distinguish between an
investment’s diversifiable and nondiversifiable risk.

P8-9 Personal finance: Rate of return, standard deviation, coefficient of variation (LG 2; Challenge)
a.
Stock Price
Year Beginning End Returns
2015 $14.36 $21.55 50.07%
2016 21.55 64.78 200.60%
2017 64.78 72.38 11.73%
2018 72.38 91.80 26.83%
Average return = 72.31%

b. Standard deviation is given by: ,

where rj is return in year j (running to year n) and r is average return over n years. In this
problem:
Average Difference
Year Returns Return Difference Squared
2015 50.07% 72.31% -22.24% 0.04945064
2016 200.60% 72.31% 128.29% 1.64589656
2017 11.73% 72.31% -60.58% 0.36696335
2018 26.83% 72.31% -45.48% 0.20682030
Sum of Squared Differences = 2.26913085
n-1 = 3
Sum of Squared Differences / ( n-1) = 0.75637695
√[Sum of Squared Differences / ( n-1)] = σ = 0.86969934
86.97%

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Chapter 8 Risk and Return 15

c. Coefficient of variation is given by CV = σ ÷ r where σ is standard deviation of returns and r is

expected return: 86.97% ÷ 72.31% = 1.2.
d. Stock price of Hi-Tech, Inc. fluctuated wildly over the four-year period and would have to be
classified as a volatile security (albeit with an upward price trend). Note how coefficient of
variation provides additional perspective—for each unit of return, the stock carries 1.2 units of
volatility. Hi-Tech stock exceeds Mike’s risk limit of a coefficient of variation of returns of 0.9.
But, depending on this personal risk-return tradeoff, Mike could make an exception and add the
Hi-Tech stock to his portfolio if he believes the recent large returns will continue.

P8-10 Assessing return and risk (LG 2; Challenge)

a. Project ACX
(1) Range: 1.00  (.10)  1.10 percentage points
(2) Expected or average return:

where ri = return for outcome i, and Pri is probability of outcome i:

Project ACX

Return Probability Weighted Value (ri – r) x Pri

ri Pri

0.01 –0.1 5.69

–10
10 0.03 0.3 –11.07

20 0.05 1 -26.9

30 0.05 1.5 –25.35

40 0.35 14 –96.6

50 0.25 12.5 38.75

60 0.15 9 117.9

70 0.05 3.5 80.85

80 0.03 2.4 79.44

90 0.02 1.8 77.58

100 0.01 1.0 53.10

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16 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

= 46.9 σ 2=293.39

(3) Standard deviation: , where:

ri is the return for outcome i, is the average return across all outcomes, and Pri is the
probability of outcome i. σ = √ 293.39 = 17.13 %

(4) Coefficient of variation (CV) is given by σ ÷ , where σ is the standard deviation of the
returns on the asset and is the average return. So: CV = 17.13% ÷ 46.9% = 0.3652

Project ACY
(1) Range: 0.55  0.10  0.45 percentage points
(2) Expected or average return:

where ri = return for outcome i, and Pri is probability of outcome i:

Project ACY

Return Probability Weighted Value (ri – r) x Pri

ri Pri

10 0.05 0.5 –10.175

15 0.10 1.5 –23.025

20 0.10 2 –20.7

25 0.15 3.75 –20.0625

30 0.24 7.2 –2.52

40 0.25 10 96.5

45 0.05 2.25 32.9625

50 0.03 1.5 29.475

55 0.03 1.65 40.673

= 30.35 σ 2= 123.1275

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Chapter 8 Risk and Return 17

(3) Standard deviation: , where:

ri is the return for outcome i, is the average return across all outcomes, and Pri is the
probability of outcome i. σ = √ 123.1275= 11.096 %

(4) Coefficient of variation (CV) is given by σ ÷ , where σ is the standard deviation of returns
on the asset and is the average return. So, CV = 11.096% ÷ 30.35% = 0.3656.

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18 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

b. Bar charts

Project ACX Return Distribution Project ACY Return Distribution

0.4 0.30
0.35 0.25
0.3
0.25 0.20
0.2 0.15
0.15 0.10
0.1
0.05 0.05
0 0.00
-10 10 20 30 40 50 60 70 80 90 100 10 15 20 25 30 40 45 50 55

Project ACX Return % Project ACY Return %

c. The primary criteria for assessing risk should be coefficient of variation. As both the projects
have very similar coefficients of variation, we need to look elsewhere. Another measure of risk
can be standard deviation of returns. Project ACX has a standard deviation of 17.163%, making it
a relatively more risky project.

P8-11 Integrative: Expected return, standard deviation, and coefficient of variation

(LG 2; Challenge)

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Chapter 8 Risk and Return 19

a. Expected or average return:

where ri = return for outcome i, and Pri is probability of outcome i:

Return Probability Weighted Value

Asset ri P ri r i x P ri
0.40 0.100 0.0400
0.10 0.200 0.0200
F 0.00 0.400 0.0000
-0.05 0.200 -0.0100
-0.10 0.100 -0.0100
Sum = 1.000 Sum = Average Return (r̅) = 0.040000
= 4.0%
Asset ri P ri r i x P ri
0.35 0.400 0.1400
G 0.10 0.300 0.0300
-0.20 0.300 -0.0600
Sum = 1.000 Sum = Average Return (r̅) = 0.110000
= 11.0%
Asset ri P ri r i x P ri
0.40 0.100 0.0400
0.20 0.200 0.0400
H 0.10 0.400 0.0400
0.00 0.200 0.0000
-0.20 0.100 -0.0200
Sum = 1.000 Sum = Average Return (r̅) = 0.100000
= 10.0%

Asset G provides the largest average return.

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20 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

b. Standard deviation: , , where ri is the return for outcome i, is the

average return across all outcomes, and Pri is the probability of outcome i.

Asset F
Column → (1) (2) (3) (4) (5) (6)
Return Average Probability
2
(r i ) Return (r̅) = (1) ─ (2) = (3) (P ri ) = (4) x (5)
0.40 0.04 0.360 0.1296
0.100 0.012960
0.10 0.04 0.060 0.0036
0.200 0.000720
0.00 0.04 -0.040 0.0016
0.400 0.000640
-0.05 0.04 -0.090 0.0081
0.200 0.001620
-0.10 0.04 -0.140 0.0196
0.100 0.001960
Sum = 0.017900
√ (Sum) = Standard Deviation (σ) = 0.133791
= 13.38%
Asset F
Column → (1) (2) (3) (4) (5) (6)
Return Average Probability
2
(r i ) Return (r̅) = (1) ─ (2) = (3) (P ri ) = (4) x (5)
0.40 0.04 0.360 0.1296
0.100 0.012960
0.10 0.04 0.060 0.0036
0.200 0.000720
0.00 0.04 -0.040 0.0016
0.400 0.000640
-0.05 0.04 -0.090 0.0081
0.200 0.001620
-0.10 0.04 -0.140 0.0196
0.100 0.001960
Sum = 0.017900
√ (Sum) = Standard Deviation (σ) = 0.133791
= 13.38%

Asset G
Column → (1) (2) (3) (4)
(5) (6)
Return Average Probability
2
(r i ) Return (r̅) = (1) ─ (2) = (3) (P ri ) = (4) x (5)
0.35 0.11 0.240 0.0576 0.400 0.023040
0.10 0.11 -0.010 0.0001 0.300 0.000030
-0.20 0.11 -0.310 0.0961 0.300 0.028830
Sum = 0.051900
√ (Sum) = Standard Deviation (σ) = 0.227816
= 22.78%

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Chapter 8 Risk and Return 21

Asset H
Column → (1) (2) (3) (5) (4) (6)
Return Average Probability
2
(r i ) Return (r̅) = (1) ─ (2) = (3) (P ri ) = (4) x (5)
0.40 0.10 0.300 0.0900 0.100 0.009000
0.20 0.10 0.100 0.0100 0.200 0.002000
0.10 0.10 0.000 0.0000 0.400 0.000000
0.00 0.10 -0.100 0.0100 0.200 0.002000
-0.20 0.10 -0.300 0.0900 0.100 0.009000
Sum = 0.022000
√ (Sum) = Standard Deviation (σ) = 0.148324
= 14.83%

Based on standard deviation, Asset G appears to have the greatest risk.

c. Coefficient of variation (CV) is given by σ

÷ , where so σ is the standard deviation of returns on

the asset and is the average return. So:

Asset F: CV = 0.1338 ÷ 0.04 = 3.345 Asset H: CV = 0.1483 ÷ 0.10 = 1.483
Asset G: CV = 0.2278 ÷ 2.071
As measured by the coefficient of variation, Asset F has the largest relative risk.

P8-12 Normal probability distribution (LG 2; Challenge)

a. σ = CV × = 0.65 × 16% = 10.4%

b. (1) 68% of the outcomes will lie between 1 standard deviation from the expected value:
+1 σ = 16% + 10.4% = 26.4% –1 σ = 16% – 10.4% = 5.6%

(2) 95% of the outcomes will lie between 2 standard deviations from the expected value:
+2 σ = 16% + (2 × 10.4%) = 36.8% – 2 σ = 16% – (2 × 10.4%) = –
4.8%

(3) 99% of the outcomes will lie between 3 standard deviations from the expected value:
+2 σ = 16% + (3 × 10.4%) = 47.2% – 2 σ = 16% – (3 × 10.4%) = –
15.2%

c.
Data Point Return

1 –15.20%

2 –4.80%

3 5..6%

4 16%

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22 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

5 26.40%

6 36.80%

7 47.20%

Probability Distribution
60
50
40
30
20
10
0
0 1 2 3 4 5 6 7 8

P8-13 Personal finance: Portfolio return and standard deviation (LG 3; Challenge)
a. Actual portfolio return for each year: rp  (wLrL)  (wMrM), where w is the portfolio
weight of asset L or M, and r is the actual return in a given year on asset L or M.

Year Asset L (wLrL)  Asset M (wMrM) Portfolio Return (rp)

2013 (14%  0.40   (20%0.60   17.6%
5.6%) 12.0%)
2014 (14%  0.40   (18%0.60   16.4%
5.6%) 10.8%)
2015 (16%  0.40  (16%0.60   16.0%
6.4%) 9.6%)
2016 (17%  0.40   (14%0.60   15.2%
6.8%) 8.4%)
2017 (17%  0.40   (12%0.60   14.0%
6.8%) 7.2%)
2018 (19%  0.40   (10%0.60   13.6%
7.6%) 6.0%)
b. Average return, Asset L (rL): (14% + 14% + 16% + 17% + 17% + 19%) ÷ 6 = 0.16167 = 16.2%
Average return, Asset M (rM): (20% + 18% + 16% + 14% + 12% + 10%) ÷ 6 = 0.15000 =15.0%
Portfolio return (rp): (17.6% + 16.4% + 16.0% + 15.2% + 14.0% + 13.6%) ÷ 6 = 0.15467 = 15.5%

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Chapter 8 Risk and Return 23

c. Standard deviation for Asset L and Asset M: ,

where ri is the asset return in year i (running to year n), and is average return over n years:
Asset L
Column → (1) (2) (3)
Return Average
2
Year (r i ) Return (r̅) = (1) ─ (2) = (3)
2013 0.14000 0.16167 -0.022 0.000469
2014 0.14000 0.16167 -0.022 0.000469
2015 0.16000 0.16167 -0.002 0.000003
2016 0.17000 0.16167 0.008 0.000069
2017 0.17000 0.16167 0.008 0.000069
2018 0.19000 0.16167 0.028 0.000803
Sum of Squared Differences = 0.001883
n─1= 5
Sum of Squared Differences / (n ─ 1) = 0.000377
√ [Sum of Squarted Differences) / (n ─ 1)] = σ = 0.019408
= 1.94%
Asset M
Column → (1) (2) (3)
Return Average
2
Year (r i ) Return (r̅) = (1) ─ (2) = (3)
2013 0.20000 0.15000 0.050 0.002500
2014 0.18000 0.15000 0.030 0.000900
2015 0.16000 0.15000 0.010 0.000100
2016 0.14000 0.15000 -0.010 0.000100
2017 0.12000 0.15000 -0.030 0.000900
2018 0.10000 0.15000 -0.050 0.002500
Sum of Squared Differences = 0.007000
n─1= 5
Sum of Squared Differences / (n ─ 1) = 0.001400
√ [Sum of Squarted Differences) / (n ─ 1)] = σ = 0.037417
= 3.74%

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24 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

Portfolio
Column → (1) (2) (3)
Return Average
2
Year (r i ) Return (r̅) = (1) ─ (2) = (3)
2013 17.6% 0.15 0.021 0.000455
2014 16.4% 0.15 0.009 0.000087
2015 16.0% 0.15 0.005 0.000028
2016 15.2% 0.15 -0.003 0.000007
2017 14.0% 0.15 -0.015 0.000215
2018 13.6% 0.15 -0.019 0.000348
Sum of Squared Differences = 0.001141
n─1= 5
Sum of Squared Differences / (n ─ 1) = 0.000228
√ [Sum of Squarted Differences) / (n ─ 1)] = σ = 0.015108
= 1.51%

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Chapter 8 Risk and Return 25

d and e.
The standard deviation (risk) of portfolio returns is 1.51%, lower than either asset (1.94% for
Asset L and 3.74% for Asset M). So holding the two assets as a portfolio yields a diversification
benefit, indicating the returns on Asset L and M must be less than perfectly positively correlated.
[Note: The actual correlation coefficient between the returns on Asset L and Asset M is
-0.9635—the assets are highly negatively correlated—but negative correlation is not necessary
for a diversification benefit.]

P8-14 Portfolio analysis (LG 3; Challenge)

a. Expected portfolio return:
Alternative 1: 100% Asset F

Alternative 2: 50% Asset F  50% Asset G

Asset F Asset G Portfolio Return
Year (wFrF) (wGrG) rp
2016 (16%0.50   (17%0.50  16.5%
8.0%) 8.5%)
2017 (17%0.50   (16%0.50  16.5%
8.5%) 8.0%)
2018 (18%0.50   (15%0.50  16.5%
9.0%) 7.5%)
2019 (19%0.50   (14%0.50  16.5%
9.5%) 7.0%)

Alternative 3: 50% Asset F  50% Asset H

Asset F Asset H Portfolio Return
Year (wFrF) (wHrH) rp
2016 (16%0.50   (14%0.50   15.0%
8.0%) 7.0%)
2017 (17%0.50   (15%0.50   16.0%
8.5%) 7.5%)
2018 (18%0.50   (16%0.50   17.0%
9.0%) 8.0%)
2019 (19%0.50   (17%0.50   18.0%
9.5%) 8.5%)

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26 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

b. Standard deviation: ,

where ri is asset return in year i (running to year n), and is average return over n years:

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Chapter 8 Risk and Return 27

Alternative 1:
100% Asset F
Column → (1) (2) (3)
Return Average
2
Year (r i ) Return (r̅) = (1) ─ (2) = (3)
2016 16% 0.175 -0.015 0.000225
2017 17% 0.175 -0.005 0.000025
2018 18% 0.175 0.005 0.000025
2019 19% 0.175 0.015 0.000225
Sum of Squared Differences = 0.000500
n─1= 3
Sum of Squared Differences / (n ─ 1) = 0.000167
√ [Sum of Squarted Differences) / (n ─ 1)] = σ = 0.012910
= 1.291%
Alternative 2:
50% Asset F and 50% Asset G
Column → (1) (2) (3)
Return Average
2
Year (r i ) Return (r̅) = (1) ─ (2) = (3)
2016 0.16500 0.16500 0.000 0.000000
2017 0.16500 0.16500 0.000 0.000000
2018 0.16500 0.16500 0.000 0.000000
2019 0.16500 0.16500 0.000 0.000000
Sum of Squared Differences = 0.000000
n─1= 3
Sum of Squared Differences / (n ─ 1) = 0.000000
√ [Sum of Squarted Differences) / (n ─ 1)] = σ = 0.000000
= 0.00%
Alternative 3:
50% Asset F and 50% Asset H
Column → (1) (2) (3)
Return Average
2
Year (r i ) Return (r̅) = (1) ─ (2) = (3)
2016 0.15000 0.16500 -0.015 0.000225
2017 0.16000 0.16500 -0.005 0.000025
2018 0.17000 0.16500 0.005 0.000025
2019 0.18000 0.16500 0.015 0.000225
Sum of Squared Differences = 0.000500
n─1= 3
Sum of Squared Differences / (n ─ 1) = 0.000167
√ [Sum of Squarted Differences) / (n ─ 1)] = σ = 0.012910
= 1.291%

c. Coefficient of variation (CV) , where σr is standard deviation of the investment alternative

and is the average return of the investment alternative:

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28 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

d. Summary:
r CV
Alternative 1 (F) 17.5% 1.291% 0.0738
Alternative 2 (FG) 16.5% 0 0.0
Alternative 3 (FH) 16.5% 1.291% 0.0782
Alternative 1 posted the highest return but Alternative 2 the lowest volatility (risk). When
thinking about performance, it is instructive to ask how a hypothetical investor might view these
alternatives. She would first note Alternative 2 is clearly preferable to Alternative 3 because it
offers the same expected return but no volatility in returns. Now, as between Alternatives 1 and 2,
Alternative 1 offers a higher expected return but also has more volatile returns. Without knowing
an investor’s risk tolerance, it is not possible to say whether Alternative 1 or 2 is “best.”

P8-15 Correlation, risk, and return (LG 4; Intermediate)

a. (1) Range of expected return: between 10% and 15%
(2) Range of the risk: between 5% and 8%
b. (1) Range of expected return: between 8% and 13%
(2) Range of the risk: 0 < risk 8%
c. (1) Range of expected return: between 8% and 13%
(2) Range of the risk: 0 < risk < 8%

P8-16 Personal finance: International investment returns (LG 1 and LG 4; Intermediate)

a. Return Pesos  (24.75 – 20.5) ÷ 20.5 = 0.20732 = 20.73%
b. Purchase price Beginning of Year = Price in pesos ÷ Pesos per dollar = $2.22584 × 1,000 = $2,225.84
Purchase price End of Year = Price in pesos ÷ Pesos per dollar = $2.51269 × 1,000 = $2,512.69
c. Return Dollars  ($2,512.69 – $2,225.84) ÷ $2,225.84 = 0.20732 = 0.12887 = 12.89%
d. The two returns differ because of the change in the exchange rate between the peso and the dollar.
The peso depreciated against the dollar by 6.5% between the purchase and sale dates, thereby
reducing total return. The return in dollars in part (c) is the more important of the two returns for
Joe because it shows the change in his real command over goods and services in the country
where he lives. The key point here is that an investor in foreign securities should understand
exchange-rate risk—the risk adverse movements in exchange rates will lower total return.

P8-17 Total, non-diversifiable, and diversifiable risk (LG 5; Intermediate)

a. and b.

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Chapter 8 Risk and Return 29

c. Only nondiversifiable risk is relevant because, as shown above, building a portfolio of at least 20
securities with imperfectly correlated returns substantially reduces diversifiable risk. When
additional securities no longer reduce risk, the remaining standard deviation of David Talbot’s
portfolio is non-diversifiable. That standard deviation of returns of 6.47% (down from 14.50%).

P8-18 Graphic derivation of beta (LG 5; Intermediate)

a.
Deriving Beta
40.0% Asset
Returns
35.0%

30.0%
Asset B
Beta = 1.38
25.0%

20.0%

15.0%
Asset A
Beta = 0.793
10.0%

5.0%

0.0%
-13.0% -8.0% -4.0% 0.0% 2.0% 6.0% 8.0% 10.0% 13.0% 15.0% 16.0%
-5.0% Market
Return
-10.0%

-15.0%

b. The betas for assets A and B are the slopes of the characteristic lines above. Typically, the slopes
of these lines are estimated with a statistical technique known as linear regression. But, slope can
also be calculated given any two points on a line. Here, we can obtain slopes (i.e., betas) with the
highest and lowest returns for each asset. Specifically:

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30 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

Beta = ∆ Asset Return ÷ ∆ Market Return

BetaAsset A = Highest Return on Asset A – Lowest Return on Asset A
Highest Market Return – Lowest Market Return

= [0.19 – (–0.04)] ÷ [0.16 – (–0.13)] = 0.23 ÷ 0.29 = 0.793

BetaAsset B = Highest Return on Asset B – Lowest Return on Asset B

Highest Market Return – Lowest Market Return
= [0.30 – (–0.10)] ÷ [0.16 – (–0.13)] = 0.40÷ 0.29 = 1.38
c. With a higher beta, Asset B has more nondiversifiable risk (i.e., the risk that really matters to
investors). For each one percentage point movement in the market return, Asset B will move 1.38
percentage points (compared with 0.793 percentage points for Asset B).

P8-19 Graphic derivation of beta (LG 5; Intermediate)

a. The returns for Biotech are more disperse, so it has a higher standard deviation.
b. The slope of the line is greater for Cyclical, which means that Cyclical stock tends to move more
when the market moves than the Biotech stock. Thus, Cyclical has the higher beta.
c. Cyclical has the higher beta (more nondiversifiable risk), so it should offer the higher expected
return. Biotech is more volatile, but diversification can eliminate most of that risk. Only if forced
to hold Cyclical or Biotech in isolation would Biotech be riskier (and even then an investor
holding Biotech should not expect the market to reward him with a higher return).

P8-20 Interpreting beta (LG 5; Basic)

Effect of change in market return on asset with beta of 0.8 if market return rises by:

a. 0.8 × (42%) = 33.6% increase in the asset’s return.

b. 0.8 × (−32%) = −25.6% decrease in the asset’s return.

c. 0.8 × (0%) = no change in the asset’s return.

d. The asset is less risky than the market portfolio, which has a beta of 1. The higher beta makes
the return move more than the market.

P8-21 Betas (LG 5; Basic)

a., b. ∆ Market ∆ Asset ∆ Market ∆ Asset
Asset Beta Return Return Asset Beta Return Return
W 0.90 × 0.10 = 0.09 W 0 × 0.10 0.09

X 0.60 × 0.10 = 0.06 X  × 0.10 0.06

Y .80 × 0.10  0.18 Y  × 0.10 0.18

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Chapter 8 Risk and Return 31

Z 2.30 × 0.10 = 0.23 Z 2 × 0.10  0.09

c. Asset X should be chosen because it is a defensive asset, moving in opposition to the market. In
an economic downturn, Asset X’s return is increasing.
d. Asset Z would be the appropriate choice because it will have the highest increase in return.

P8-22 Personal finance: Betas and risk rankings (LG 5; Intermediate)

a. From most risky to least risky: B > A > C

b. and part ©.
∆ Market ∆ Asset ∆ Market ∆ Asset
Asset Beta
Return Return Return return

A 0.75 15% 11.25% -10% -7.50%

-
B 1.6 15% 24.00% -10%
16.00%

C -0.5 15% -7.50% -10% 5.00%

d. If you believe that the stock market is going to experience a significant decline, stocks with
negative Betas should be chosen. In this case Thomas should choose stock C.
e. If you believe that the stock market is going to experience a significant rally, stocks with high
positive Betas should be chosen. In this case Thomas should choose stock B.

P8-23 Personal finance: Portfolio betas (LG 5; Intermediate)

The beta of a portfolio is simply the weighted average of the betas of the individual securities in the
portfolio, with portfolio shares serving as weights. More formally:
n
β p ∑ w j × β j,
j=1

where β p is portfolio beta, β j is beta of asset j, and w j = portfolio share of the asset j (running to n)
a.
Portfolio X Portfolio Y

Asset Beta WX WX × bX WY WY × bY

1 2.5 0.20 0.50 0.10 0.25

2 0.8 0.10 0.08 0.30 0.24

3 1.2 0.30 0.36 0.10 0.12

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32 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

4 0.9 0.10 0.09 0.30 0.27

5 1.6 0.30 0.48 0.20 0.32

bX = 1.51 bY = 1.20

b. Portfolios X and Y are both more risky than the market (average risk). Comparatively speaking,
Portfolio Y is slightly less risky than Portfolio X. Portfolio X’s return will move more than
Portfolio Y’s for a given increase or decrease in the market return. Thus, Portfolio X is more
risky.

P8-24 Capital asset pricing model—CAPM (LG 6; Basic)

The CAPM equation is rj  RF  [j(rm  RF)], where rj is the expected/required return on asset j,
j is beta for asset j, RF is the risk-free rate, and rm is the expected return on the market portfolio:
Case rj = RF + [bj × (rm − RF)]

A 44.4% = 6% + [2.40 × (22% − 6%)]

B 0.5% = 3% + [–0.50 × (8% − 3%)]

C 14.5% = 10% + [0.90 × (15% − 10%)]

D 18.0% = 12% + [1.00 × (18% − 12%)]

E 8.5% = 5% + [0.70 × (10% − 5%)]

P8-25 Personal finance: Beta coefficients and the CAPM (LG 5 and LG 6; Intermediate)
The CAPM equation is rj  RF  [j(rm  RF)], where rj is the expected or required return on asset
j, j is the beta coefficient for asset j, RF is the risk-free rate, and rm is the expected return on the
market portfolio. The problem provides values for rj, RF and rm and asks for beta; using the CAPM
equation:
(i) rj  RF  [j(rm  RF)] (iii) j(rj  RF) ÷ (rm  RF)]
(ii) rj  RF  j(rm  RF)

13 %−3 % 10 %
Beta= = =1. 1111
a. 12 %−3 % 9 %

25 %−3 % 22%
Beta= = =2. 4444
b. 12 %−3 % 9 %

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Chapter 8 Risk and Return 33

16 %−3 % 13 %
Beta= = =1. 4444
c. 12 %−3 % 9 %

18 %−3 % 15 %
Beta= = =1. 6666
d. 12 %−3 % 9 %

e. If you are willing to take a maximum of average risk, then you will have an
expected return of only 12% (r = 3% + 1.0  (12% − 3%) = 12%).

P8-26 Manipulating CAPM (LG 6; Intermediate)

a. rj = 5% + [2.2 × (32% − 5%)]

rj = 64.4%

b. 23.75% = RF + [1.25 × (20% − RF)]

RF = 5%

c. 18% = 8% + [1.2 × (rm − 8%)]

rm = 16.33%

d. 15% = 3% + [bj × (15% − 3%)

bj = 1

In a declining market, an investor should choose stock with a negative beta. When the market
return decreases, the return on C increases.

If you are expecting a potential market rally, an investor should choose an aggressive stock like
stock B. Its return will be higher than the market return in a booming market.

P8-27 Personal finance: Portfolio return and beta (LG 1, LG 2, LG 3, LG 5, and LG 6: Challenge)
a. The beta of a portfolio assets is the weighted average of the betas of the individual assets in the
portfolio, with the weight on each asset being that asset’s share in the portfolio. Specifically,
n n
β p = ∑ w j × β j and ∑ w j = 1 → β p  (w A × β A )  (w B × β B )  (w C × βC )  (w D × β D)
j=1 j=1

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34 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

Asset Cost Weight (w j ) Beta (βj )

A $ 20,000 20% 0.80 0.1600
B $ 35,000 35% 0.95 0.3325
C $ 30,000 30% 1.50 0.4500
D $ 15,000 15% 1.25 0.1875
Total = $ 100,000 100% Sum = βp = 1.1300

b.

rA rC

rB rD

c. Total value of the portfolio today is $107,500, and total annual income from Assets A–D during
the year was $3,375, so portfolio return is given by:

rP
d. Using the CAPM equation, rj  RF  [ β j (rm  RF)], where rj is the required return on asset j,
RF the risk-free rate (given as 4%), β j the beta on asset j and rm the return on the market portfolio
(given as 10%), solve for required return on each project:
rA  4%  [0.80(10%  4%)] = 8.8% rC  4%  [1.50(10%  4%)] = 13.0%
rB  4%  [0.95(10%  4%)] = 9.7% rD  4%  [1.25(10%  4%)] = 11.5%
e.

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Chapter 8 Risk and Return 35

Over- or
Actual CAPM Underperformed
Asset Return Return CAPM
A 8.00% 8.80% Under
B 6.86% 9.70% Under
C 15.00% 13.00% Over
D 12.50% 11.50% Over

Security analysts typically use statistical techniques to estimate an asset’s beta by obtaining a line
of best fit through historical asset and market returns. The slope of this line is beta. Data points—
that is, actual returns on the asset and market for a given period—will be randomly scattered
around the line no matter how well it “fits” the data. The point here is asset betas are estimates.
The CAPM return is, in a sense, a forecast and even good forecasts are subject to random error.
Another possibility is beta does not fully capture all nondiversifiable or systemic factors that
affect expected returns. Still another possibility is the firm behind the asset has changed, so the
beta estimated with historical data does not reflect the asset’s current beta.

P8-28 Security market line—SML (LG 6; Intermediate)

a, b, d.
Market Risk and Return
18.0% Security Market Line (SML)
Asset B
SML
16.0%
Required Return = 14.2%
Required Rate of Return

14.0% Asset A
Required Return = 12.2% Asset B
12.0% Market Risk Premium
1.3 ൈ(0.13 െ 0.09) = 5.2%
10.0%

8.0% Asset A Risk-Free Rate = 9%

Market Risk Premium
0.8 ൈ(0.13 െ 0.09) = 3.2%
6.0%

4.0%
Average Risk Asset
2.0% β=1
Market Risk Premium = 0.13 - 0.09 = 4%
0.0%
0 0.2 0.4 0.6 0.8 1.0 1.2 1.4 1.6 1.8 2.0
Beta

c. Using the CAPM equation: rj  RF  [ β j (rm  RF)], where rj is the required return on asset j,
RF the risk-free rate, β j the beta on asset j and rm the return on the market portfolio:
Asset A: rj  0.09  [0.80(0.13  0.09)] = 0.122 or 12.2%
Asset B: rj  0.09  [1.30(0.13  0.09)] = 0.142 or 14.2%
d. Asset A has the smaller beta, hence the smaller risk premium and required return. Specifically,
the risk premium is 3.2% (12.2%  9%)—compared with 5.2% for Asset B’s (14.2%  9%).

P8-29 Shifts in the security market line (LG 6; Challenge)

a, b, c, d.

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36 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

b. Using the CAPM equation: rA  RF  [ β A (rm  RF)], where RF is the risk-free rate (here 8%),
β A the beta on asset A (here 1.1) and rm the return on the market portfolio (here 12%), solve for
rA is the required return on asset A: rA  8%  [1.1(12%  8%)] = 8%  4.4% = 12.4%.

c. Using the CAPM equation, rA = RF  [ β A (rm  RF)], with RF = 6%, β A = 1.1 and rm = 10%,
solve for rA  6%  [1.1(10%  6%)] = 6%  4.4% = 10.4%.

d. Using the CAPM equation, rA  RF  [ β A(rm  RF)], with RF = 8%, β A = 1.1 and rm = 13%,
solve for rA = 8%  [1.1(13%  8%)] = 8%  5.5% = 13.5%.

e. (1) A decline in inflationary expectations reduces required return by the same amount for every
beta—that is, produces a parallel downward shift of the SML. (2) Increased risk aversion gives
the SML a steeper slope because a higher return is now be required for each beta.

P8-30 Integrative: Risk, return, and CAPM (LG 6; Challenge)

a. Using the CAPM equation, rj  RF  [ β j (rm  RF)], where RF is the risk-free rate, β j the
project beta  and rm the return on the market portfolio, solve for rj is the required return on each
project j:

Project RF  [ β j (rm  RF)] rj

A 9%  [1.5(14%  9%)]  16.50%
B 9%  [0.75(14%  9%)]  12.75%
C 9%  [2.0(14%  9%)]  19.00%
D 9%  [0.0(14%  9%)]  9.00%
E 9%  [(0.5)(14%   6.50%
9%)]
b., c., and d. See SML graph below.

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Chapter 8 Risk and Return 37

c. The premium for project j’s nondiversifiable risk is β j (rm  RF). In words, the spread between
the return on the market portfolio and risk-free rate is the risk premium necessary to induce a
manager to undertake a project of average risk (i.e., one with the same nondiversifiable risk as the
market portfolio). Multiplying this spread by the project beta—the co-movement of project
returns with the market return—yields the risk premium for the project’s nondiversifiable risk.
Projects A and C have more nondiversifiable risk than the market because their betas exceed 1.0;
they require risk premiums above the average risk premium. Projects B, D, and E have less
nondiversifiable risk than the market because their betas are less than 1.0; they carry risk
premiums below the average risk premium). Projects D and E are particularly noteworthy. Project
D requires no premium for nondiversifiable risk because its beta is 0. Project E has a negative
beta, meaning its return moves in the opposite direction of the market. Required return for Project
E will actually be less than the risk-free rate.
d. rA  9%  [1.5(12%  9%)] 13.50% rD  9%  [0.0(12%  9%)] 9.00%
rB  9%  [0.75(12%  9%)] 11.25% rE  9%  [0.5(12%  9%)]
7.50%
rC  9%  [2.0(12%  9%)] 15.00%

e. When investor risk aversion declines, investors require lower returns for any given risk level
(beta). The SML will rotate clockwise about the fixed risk-free rate (because the risk premium for
an zero-beta asset will remain zero).

P8-31 Ethics problem (LG 1; Intermediate)

Investors expect managers to take risks with their money, so it is not unethical for managers to make
risky investments with other people’s money. Managers do, however, have a duty to communicate
truthfully with investors about the risk they take. Portfolio managers should not take risks they do not
expect to generate returns sufficient to compensate investors for systemic risk.

 Case: Analyzing Risk and Return on Chargers Products’ Investments

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38 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

Case studies are available on [Link]/mylab/finance

This case requires students to use standard deviation, coefficient of variation, and CAPM to assess the trade-
off between risk and return for two possible investments.

a. Actual annual return for period t is given by ,

where Pt is the end-of-year value, Pt-1 is the beginning-of-year value, and Ct is cash flow during the year.

Cash Ending Beginning Gain/ Annual Rate

Asset X: Year Flow (Ct) Value (Pt) Value (Pt – 1) Loss of Return
1 $1 $2 $20,0 $2 15.00%
00
2 1, 21, 22,00 1 2.27
0
3 1, 24, 21,00 3, 20.95
0
4 1, 22, 24,00 2 1.25
0
5 1, 23, 22,00 1, 13.18
0
6 1, 26, 23,00 3, 20.00
0
7 1, 25, 26,00 1 2.69
0
8 2, 24, 25,00 1 4.00
0
9 2, 27, 24,00 3, 21.25
0
10 2, 30, 27,00 3, 19.26
0
Ten-Year Average = 11.74%

Cash Ending Beginning Gain/ Annual Rate

Asset Y: Year Flow (Ct) Value (Pt) Value (Pt – 1) Loss of Return (rt)
1 $1 $20 $20,0 $ 7.50%
0
0
2 1, 20, 20,00 0 8.00
0
3 1, 21, 20,00 1,0 13.50
0
4 1, 21, 21,00 0 8.57
0

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Chapter 8 Risk and Return 39

5 1, 22, 21,00 1,0 13.81

0
6 2, 23, 22,00 1,0 13.64
0
7 2, 23, 23,00 0 9.13
0
8 2, 24, 23,00 1,0 13.91
0
9 2, 25, 24,00 1,0 13.75
0
10 2, 25, 25,00 0 9.60
0
Ten-Year Average = 11.14%
Mr. Sayou anticipates expected annual return over the next ten years will match average return over the
past 10 years, so expected return on AssetXis 11.74%, and expected return on Asset Y is 11.14%.

b. Standard deviation of returns is given by   ,

where rt is return in year t, is average return over n years, and n is the number of years. For Asset X:

Asset X: Year rt rt – (rt – )2

1 15.00% 11.74% 3.26% 0.001063
2 2.27 11.74 9.47 0.008968
3 20.95 11.74 9.21 0.008482
4 1.25 11.74 12.99 0.016874
5 13.18 11.74 1.44 0.000207
6 20.00 11.74 8.26 0.006823
7 2.69 11.74 -9.05 0.008190
8 4.00 11.74 7.74 0.005991
9 21.25 11.74 9.51 0.009044
10 19.26 11.74 7.52 0.005655
Sum of Squared Differences = 0.071297

Coefficient of Variation (CVx) = x ÷ r̅ x = 8.90% ÷ 11.74% = 0.76

Asset Y: Year rt rt – (rt – )2

1 7.50% 11.14% 3.64% 0.001325
2 8.00 11.14 3.14 0.000986
3 13.50 11.14 2.36 0.000557
4 8.57 11.14 2.57 0.000660
5 13.81 11.14 2.67 0.000713

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40 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

6 13.64 11.14 2.50 0.000625

7 9.13 11.14 2.01 0.000404
8 13.91 11.14 2.77 0.000767
9 13.75 11.14 2.61 0.000681
10 9.60 11.14 1.54 0.000237
Sum of Squared Differences = 0.0
0
6
9
5
5

÷ r̅ ÷
, and CVy = y y = 2.78% 11.14% = 0.25.
c. Summary statistics Asset Asset Y
X
Expected return 11.74% 11.14%
Standard deviation 8.90% 2.78%
Coefficient of variation 0.76 0.25
Comparing expected returns calculated in part (a), Asset X provides a return only slightly above that
from Asset Y. At the same time, both the standard deviation of returns and coefficient of variation for
Asset X are roughly three times greater than that for Asset Y. So Asset X appears significantly riskier
than Asset Y. But the problem notes Mr. Sayou is choosing between X and Y to add to a diversified
portfolio. That means he should care only about the nondiversifiable risk of the two assets. Standard
deviation and coefficient of variation are measures of the total volatility of returns from both
diversifiable and nondiversifiable shocks. For this reason, the better asset cannot be determined.
d. Using the CAPM equation: rj  RF  [ β j (rm  RF)], where rj is the required return on asset j,
RF the risk-free rate, β j the beta on asset j and rm the return on the market portfolio, the required returns
on Asset X and Y are:
CAPM Required Expected Return
Asset RF  [ j(rm  RF)]
β = Return Part (a)
X 7%  [1.6(10%  = 1 11.74%
7%)] 1
.
8
%
Y 7%  [1.1(10%  = 1 11.14%
7%)] 0
.
3
%

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Chapter 8 Risk and Return 41

Of the two assets, only Asset Y offers an expected return above the required return determined by
CAPM. Moreover, required return is calculated with the correct risk measure—beta—which captures
nondiversifiable risk.
e. Mr. Sayou wants to add X or Y to a diversified portfolio, so he should care only about the
nondiversifiable risk of the two assets. [Standard deviation and coefficient of variation measure total
volatility of returns from both diversifiable and nondiversifiable shocks.] CAPM will indicate the
required return for the two assets based on their nondiversifiable risk ( β x = 1.60 and β y = 1.10). As
noted, of the two assets only Y offers an expected return above required return (based on
nondiversifiable risk). So Asset Y should be recommended.
f. (1) A one percentage point rise in expected inflation will boost the risk-free rate to 8% and market
return to 11% and have the following effect on rx and ry:
CAPM: Required Expected Return
Asset RF  [bj(rm RF)] = Return (rj) Part (a)
X 8%  [1.6(11%  = 12.8% 11.74%
8%)]
Y 8%  [1.1(11%  = 11.3% 11.14%
8%)]

CAPM Required Expected Return Difference

Asset RF  [bj(rm RF)] = Return (rj) Part (a) (Percentage Points)
X 7%  [1.6(9%  = 10.2% 11.74% 1.54
7%)]
Y 7%  [1.1(9%  = 9.2% 11.14% 1.94
7%)]

 Spreadsheet Exercise
Answers to Chapter 8’s stock portfolio analysis spreadsheet problem are available on
[Link]/mylab/finance.

 Group Exercise
Group exercises are available on [Link]/mylab/finance.

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42 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

This exercise will give students insight into the world of stock-market analysis. Each group is asked to obtain
stock-market data from several websites on the recent performance of its shadow firm and compare the
numbers with a relevant market index over one and five years. Students will calculate annual returns,
investigate correlation between returns and the market return, and graph the results. As always, the instructor
can modify the exercise the meet class needs, perhaps by adding other corporations to the comparison(s) and
dropping more complex calculations.

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