Foundation of Finance Questions
Chapter 12: Questions and Problems
#1 Analyze the expert’s answers to the following questions:
a. Question: I have approximately one-third of my investments in stocks, and the rest
in a money market. What do you suggest as a somewhat “safer” place to invest
another one-third? I like to keep one-third accessible for emergencies.
Expert’s answer: Well, you could try 1- or 2-year Treasury bonds. You’d get a little
bit more yield with no risk.
b. Question: Where would you invest if you were to start today? Expert’s answer:
That depends on your age and short-term goals. If you are very young—say, under
40—and don’t need the money you’re investing for a home or college tuition or
such, you would put it in a stock fund. Even if the market tanks, you have time to
#2 Suppose that your 58-year-old father works for the Ruffy Stuffed Toy Company and
has contributed regularly to his company-matched savings plan for the past 15 years.
Ruffy contributes $0.50 for every $1.00 your father puts into the savings plan, up to the
first 6% of his salary. Participants in the savings plan can allocate their contributions
among four different investment choices: a fixed-income bond fund; a “blend” option
that invests in large companies, small companies, and the fixed-income bond fund;
a growth-income mutual fund whose investments do not include other toy companies;
and a fund whose sole investment is stock in the Ruffy Stuffed Toy Company. Over
Thanksgiving vacation, Dad realizes that you have been majoring in finance and
decides to reap some early returns on that tuition money he’s been investing in your
education. He shows you the most recent quarterly statement for his savings plan, and
you see that 98% of its current value is in the fourth investment option, that of the
Ruffy Company stock.
a. Assume that your Dad is a typical risk-averse person who is considering retirement
in five years. When you ask him why he has made the allocation in this way, he
responds that the company stock has continually performed quite well, except for
a few declines that were caused by problems in a division that the company has
long since sold off. In addition, he says, many of his friends at work have done
the same. What advice would you give your dad about adjustments to his plan
allocations? Why?
b. If you consider the fact that your dad works for Ruffy in addition to his 98%
allocation to the Ruffy stock fund, does this make his situation more risky, less
risky, or does it make no difference? Why?
#5. Given the information below about the risks and returns of five alternative portfolios,
plot the risks and returns. Which do not represent efficient portfolios? (SEE END OF TEXTBOOOK CHAPTER 12 QUESTION 5 FOR TABLE)
#7 Consider two assets with expected returns and risk given in the table below.
(SEE END OF TEXTBOOK CHAPTER 12 QUESTION 7 FOR TABLE)
If these asset returns have a correlation coefficient of 0.5, what is the risk and return of
a portfolio equally divided between the two securities? What mix of the two securities
produces the portfolio having the lowest risk? What level of risk is this?
Chapter 13: Questions and Problems
#4. If the Treasury bill rate is currently 0.04 and the expected return to the market
portfolio over the same period is 0.12, determine the risk premium on the market.
If the standard deviation of the return on the market is 0.20, what is the equation
of the Capital Market Line?
#7 If the CAPM is valid, which of the following situations is possible? Explain. Consider
each situation independently
a (SEE END OF TEXBOOK CHAPTER 13 QUESTION 7 FOR TABLE)
b (SEE END OF TEXBOOK CHAPTER 13 QUESTION 7 FOR TABLE)
c (SEE END OF TEXBOOK CHAPTER 13 QUESTION 7 FOR TABLE)
d (SEE END OF TEXBOOK CHAPTER 13 QUESTION 7 FOR TABLE)
#8. Suppose the risk-free rate is 0.10 and a security with a beta of 1 has an equilibrium
expected rate of return of 0.15. What is the equity market premium?
#24 Hint: the capitalization rate you compute with the CAPM- SML equation is the discount rate for the project.
The Clotted Blood Corporation, a home health supply company serving hemophiliacs,
is considering purchasing a new delivery van that will increase the radius of its service
area. For an initial outlay of $21,250 the van is estimated to produce the following
incremental net after-tax cash flows:
(SEE END OF TEXTBOOK CHAPTER 13 QUESTION 24 FOR TABLE)
In capital markets the market risk premium is 0.10 and the risk-free rate is 0.04. If the
stable beta of the company’s stock is 1.25, what is the net present value of the
investment using the estimated market capitalization rate?
