You hold a diversified portfolio of stocks and are considering investing in the

Question

   You hold a diversified portfolio of stocks and are considering investing in the XYZ Company. The firm’s 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 XYZ’s 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?

Explanation / Answer

1) XYZ's expected return = 0.7(0.15) + 0.2(0.09) + 0.1(0.2) = 0.105 + 0.018 + 0.02 = 0.125

Expected return is 12.5%.

2)As  XYZ’s beta from past returns has been calculated as 1.3 and you believe this will be the future beta. So there is going to be no deviation as predicted so standard deviation will not be effective statistic.

3) r = risk free return + beta(expected market return - risk free return)

0.07 + 1.3(0.135 - 0.07) = 0.15445

Return according to CAPM is 15.45%

4) Yes I should buy the stock because return according to CAPM is higher than the expected return

5) Financial risk : A company's financial risk is related to the company's use of financial leverage and debt financing, rather than the operational risk of making the company a profitable enterprise. Financial risk is concerned with a company's ability to generate sufficient cash flow to be able to make interest payments on financing or meet other debt-related obligations.
Business risk:

Business risk refers to the basic viability of a business, the question of whether a company will be able to make sufficient sales and generate sufficient revenues to cover its operational expenses and turn a profit. While financial risk is concerned with the costs of financing, business risk is concerned with all the other expenses a business must cover to remain operational and functioning.

6) Non diversifiable risk : Non-diversifiable risk can be referred to a risk which is common to a whole class of assets or liabilities. Theinvestment value might decline over a specific period of time only due to economic changes or other events which affect large sections of the market.

Diversifiable risk: Diversifiable risk is simply risk that is specific to a particular security or sector so its impact on a diversified portfolio is limited. An example of a diversifiable risk is the risk that a particular company will lose market share. It will not have any impact on other companies in a diversified portfolio, so the only loss to an investor holding shares in the company will be the decline in that one share.

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