You have recently graduated with a major in finance and landed a financial plann

Question

You have recently graduated with a major in finance and landed a financial planner job with Barney Smith Inc., a large financial services corporation. Your first assignment is to invest $100,000 for a client. Because the funds will be invested in a new business the client plans to start at the end of the year, you have been instructed to plan for a 1-year holding period. Further, your boss has restricted you to the investment alternatives shown in Table 1 on the attached resource, "Topic 5 Assignment Graphic Tables." (Disregard for now the items at the bottom of the data; you will fill in the blanks later.) Note that the estimated returns of American Foam (Am. Foam), a bedding company, do not always move in the same direction as the overall economy. For example, when the economy is below average, consumers purchase fewer mattresses than they would if the economy were stronger. However, if the economy is in a flat-out recession, a large number of consumers who were planning to purchase a more expensive inner-spring mattress may purchase a cheaper foam mattress instead. Under these circumstances, we would expect American Foam’s stock price to be higher if there is a recession than if the economy was just below average. Barney Smith’s economic forecasting staff has developed probability estimates for the state of the economy, and its security analysts have developed a sophisticated computer program that was used to estimate the rate of return on each alternative under several state of the economy scenarios. Alta Industries (Alta Inds) is an electronics firm; Repo Men collects past-due debts; and American Foam, as per above, manufactures mattresses and various other foam products. Barney Smith also maintains an "index fund" which owns a market-weighted fraction of all publicly traded stocks; you can invest in that fund, and thus obtain average stock market results. Given the situation as described, answer the following questions. 8. Write out the Security Market Line (SML) equation and use it to calculate the required rate of return on each alternative. Compare the expected rates of return with the required rates of return. How do these perform against your predictions? 9. Does the fact that Repo Men has an expected rate of return less than the T-bill rate of return make any sense? Why or why not? 10. What would be the market risk and the required return of a 50-50 portfolio of Alta Industries and Repo Men? Or of Alta Industries and American Foam? Based on your analysis and conclusions, which would you recommend to your client?

Explanation / Answer

Q. 8) Security Market Line equation:-

Security market line (SML) shows the expected rate of return on individual security. The SML equation is presented below:-

Expected return = Risk free rate + Beta * (Market rate of return - risk free rate)

Security market line (SML) is the symbol / representation of Capital asset pricing model (CAPM).

Comparison of Expected rate of return and Required rate of return:-

Required rate of return is the return that an investor thinks / wants before making investment. Required rate of return reflects the riskiness of an investment. Whether to make investment or seek for other investment option, required rate of return plays a vital role.

Expected rate of return is the rate which investor expects to receive on making the investment. For example, if you invested in a stock that had 60% chance of producing a 10% profit and 40% chance of producing a 5 % loss, the expected return would be 4% [0.60 * 10 + 0.40 * (-)5].

Q. 9) Yes,this fact makes a big sense if expected rate of return is less than the T-bill rate . T-bill is the minimum rate that investor seek for any investment. T-bill is the reflection of Risk free rate. The expected rate of return must always more than the T-bill rate because while making risky investment, investor always seek for more return (Risk free rate of return + risk premium).

Q. 10) Market risk is the kind of risk that an investment value may decline due to various market factors.

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