2. Consider a risky portfolio that offers an expected rate of return of 12% and
ID: 2785971 • Letter: 2
Question
2. Consider a risky portfolio that offers an expected rate of return of 12% and a standard deviation of 20%. T-bills offer a risk-free 7% return. (1) What is the certainty equivalent rate of return of the risky portfolio? What is the risk premium of the risky portfolio? 2) What Sharpe ratio) of the risky portfolio? What's the meaning of the Sharpe ratio? (3) Suppose a security investor's utility function is U-E(r)-12×A× 2 is the reward-to-volatility ratio a. If A-2, would the investor choose the risky portfolio or theTbills? b. If A-4, would the investor choose the risky portfolio or the T-bills? c. What is the maximum level of risk aversion for which the risky portfolio is still preferred to bills?Explanation / Answer
1. required rate of return for Milton = 3% +1.5*(14%-3%)= 19.5%
required rate of return for Eaton== 3% +2.2*(14%-3%)=27.5%
A. The required rate of return for Milton is 19.50%, and that for Eaton is 27.20%
2.
D. Milton is a better buy since the required rate of return is less than the expected return
3.
Re = 3% + 2.1*(10%)= 24%
WACC = 60%*16% + 40%*24%= 19.20%
B. 19.2%
4.
WACC = 20%*16% + 80%*18.5%= 18.00%
B. 18%
5.
NPV = -114500 + 19,850/1.18 +24,780/1.18^2 +33,960/1.18^3 +51,236/1.18^4 + 55,780/1.18^5=-$8403
A. NPV= -$8,403.34. Husky shall not undertake the investment project since NPV<0
6.
PI = (19,850/1.18 +24,780/1.18^2 +33,960/1.18^3 +51,236/1.18^4 + 55,780/1.18^5)/114500=0.93
D. PI = 0.93. Husky shall not undertake the investment project since PI<1
7.
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