1

CHP 5

Which of the following statements best describes time lines?

The term time zero in a time line is used to refer to the end of a transaction in time value of
money.

Time line is a vertical line that starts at time one and shows cash flows as they occur over time.

Time lines are an important tool for analyzing problems that involve cash flows over time.

Time lines provide an unpredicted way to visualize the cash flow associated with operating
decisions

Generally, the future value of an investment will be greater if:

the investment is discounted at a higher rate of return.

the investment is compounded at a lower rate of return.

the investment is compounded at a higher rate of return.

the investment is discounted at a lower rate of return.

Total compound interest is the:

sum of principal and interest on interest

difference between future value and simple interest

 2

sum of simple interest and the interest on interest

sum of principal and simple interest

Future value = Present value (1 + interest rate)n; $200,000 = $400,000 (1 + 0.1)n; $200,000 /
$400,000) = (1+0.1)n; 5 = (1.1000)n; n = 16.89 years.

Boretti has $400,000 in a stock fund. The fund pays a 10% return, compounded annually. If he does
not make another deposit into the account, how long will it take for the account to increase to $2
million? (Do not round intermediate calculations. Round the final answer to two decimal places.)

23.33 years

33.33 years

16.89 years

12.63 years

Because longer the investment period, the greater the proportion of total earnings from interest
earned on interest.

Why do earnings from compounding drive much of the return earned on a long-term investment?

A longer investment period will result in a greater proportion of total earnings from interest
earned on interest.

Interest earned on interest grows steadily as the investment amount increases.

 3

A longer investment period results in equivalent proportion of earnings from interest earned on
interest.

Interest earned on interest grows gradually as the investment period decreases.

The total amount of interest earned on an investment depends on the frequency of compounding, as
well as interest rate per year and the number of years involved.

If the interest rate per year and the number of years involved remain the same, the total amount of
interest earned on an investment will remain the same irrespective of the frequency of compounding.

True

False

The present value of future cash flows increases as the discount rate decreases.

The present value of future cash flows:

increases as the discount rate decreases.

decreases as the number of discounting periods decrease.

decreases as the discount rate decreases.

increases as the number of discounting periods increase.

Future value = Present value (1 + interest rate)n; $300,000 = PV (1 + 0.038)10; $300,000

= PV 1.038010; PV = $300,000 / 1.4520;
PV = $206,608
 4

Kathleen just received a bonus from EG. She is excited because her dad started his career with EG. If
her bonus of $300,000 is equivalent to the bonus paid to her dad 10 years ago, how much was her
dads bonus? Assume that the average annual inflation rate was 3.8%. (Do not round intermediate
calculations. Round your answer to the nearest whole dollar amount.)

$206,608

$208,902

$202,308

$276,217

Under the yearly discounting methods, the present value of an investment will be highest.

Under which of the following discounting methods will the present value of an investment be the
highest, assuming the same annual interest rate?

Monthly

Semi-annually

Yearly

Quarterly

Future value = Present value (1 + interest rate)n; $500,000 = $200,000 (1 + 0.105 /

12)n; n = 105 months
 5

If you can invest $200,000 at a 10.5% annual rate, compounded monthly, how long will it take to
have $500,000? (Do not your intermediate calculations. Round your final answer to the nearest whole
month.)

105 months

119 months

160 months

109 months

FV5 = [$4,000 (1.14)5] + [$4,000 (1.20)4] + [$4,000 (1.14)3 + [$8,000 (1.14)2] +

[$8,000 (1.14)1] + [$8,000 (1.14)0] = $7,710.66 + $6,755.84 + $5,926.18 + $9120.00
+ $8,000.00 = $42,702

You are starting college this month, and your favorite aunt has agreed to give you $4,000 at the end
of each of your four years and you can save $8,000 at the end of each year for the first two years
after you graduate. If all of these amounts are invested at 14%, how much will you have to start
graduate school, six years from now? (Round the final answer to the nearest dollar.)

$42,160

$42,702

$42,167

$42,927

A typical present value of an annuity formula assumes that cash flows occur at the end of the
period
 6

A typical present value of an annuity formula assumes that:

cash flows occur at the beginning of each period.

cash flows occur at the end of each period.

cash flows occur at random.

cash flows are adjusted for inflation

Annuity due value = Ordinary annuity value (1+i)

Which of the following equations is correct?

Annuity due value = Ordinary value (1+i)

Annuity due value = Ordinary annuity value / i

Annuity due value = Ordinary annuity value + (1+i)

Annuity due value = Ordinary annuity value / (1+i)

The future value of an annuity is typically used when analyzing retirement or pension plans
with constant contributions.

The future value of an annuity is typically used when analyzing:

 7

alternative capital budgeting proposals.

loan amortization schedules.

the price of common stock.

retirement plans.

The most important perpetuities in the securities markets today are preferred stock issues.

A modern day example of a perpetuity is a:

corporate bond.

treasury bond.

share of preferred stock.

share of common stock.

PVAn = (CF1 / (i g)) [1 ((1+g)n/ (1+i))n]

= ($123,000 / (15% 2.50%)) [1 ((1+2.5%)50 / (1+15%))50]
= $984,000 0.996828 =$980,879

Cavincare has 50 years remaining on a service contract with Martin, Inc. Today, Martin paid $120,000
for services received last year and the annual payment increases by 2.5% each year. The firms
required rate of return is 15%. What is the value of the contract to Cavincare? (Do not round
intermediate calculations. Round the final answer to the nearest whole dollar amount.)
 8

$915,000

$987,131

$974,634

$980,879

The annual percentage rate (APR) is defined as the simple interest charged per period multiplied by
the number of periods per year.

The simple interest rate charged per period multiplied by the number of payment periods per year
gives the:

effective annual interest rate

simple interest rate

compound interest rate

annual percentage rate

EAR = (1 + Quoted interest rate/m)m 1

= (1 + 18% / 4)4 1 = (1 + (0.045))4 1 = 19.3%

An investment pays 18 percent interest compounded quarterly. What is the effective annual interest
rate? (Do not round intermediate calculations. Round the final answer to the nearest one decimal.)
 9

18.9%

18.3%

19.3%

19.9%

The annual percentage rate (APR) is the annualized interest rate using simple interest.

Which of the following interest rates is annualized using simple interest?

The annual percentage rate (APR)

The effective annual rate (EAR)

The adjusted interest rate (AIR)

The discounted interest rate (DIR)

When choosing between two investments that have the same level of risk, investors prefer the
investment with the higher return.

When choosing between two investments

that have the same expected return, investors prefer the riskier alternative.
 10

that have the same expected return, investors prefer to make equal investments in both.

that have the same level of risk, investors prefer the investment with the higher return.

that have the same level of risk, investors prefer to make equal investments in both.

The total holding period return is the sum of the capital appreciation and income components of
return.

Total holding period return is the dollar gain (or loss) from purchasing an asset and selling it later.

True

False

Expected return for the asset = (0.12 15%) + (0.10 50%) + (0.07 35%) = 9.3%

Use the following table to calculate the expected return for the asset.

9.7%

10.0%
 11

9.3%

8.3%

Expected return = (0.20 0.08) + (0.10 0.10) + (0.40 0.12) + (0.20 0.15) + (0.10
0.20) = 12.4%.

Based on the table below, what is the expected return of the stock?

Probabilit
Return
y
0.20 8%
0.10 10%
0.40 12%
0.20 15%
0.10 20%

12.6%

12.8%

13.0%

12.4%

An investor will always choose an investment which has the highest return and lowest risk.
Among the three, Asset Q and Asset U have same risk and Asset U and Asset B have same
returns. Since Asset U has lower risk than Asset B, the investor will prefer Asset U.

An investor will choose between Asset Q with an expected return of 6.5% and a standard deviation of
5.5%, Asset U with an expected return of 8.8% and a standard deviation of 5.5%, and Asset B with an
expected return of 8.8% and a standard deviation of 6.5%. Which one should the investor prefer?
 12

Asset B

Asset Q

Asset U

Cannot be determined

Standard deviation is the square root of the variance. So the larger the variance, the larger the
standard deviation is.

The larger the variance, the smaller the standard deviation.

True

False

Based upon annual total returns from 19262006, small-size stock portfolio in the US had
16.53% average return and 32.32% standard deviation, which were the highest.

Based upon annual total returns from 19262006, the small-size stock portfolio in the US had the
largest average return and the highest standard deviation as well.

True

False

Covariance of returns is a measure of how the returns on two assets co-vary, or move together. It
measures absolute relationship between the returns of each pair of assets.
 13

Covariance measures _____.

the absolute relationship between the returns of each pair of assets

the market beta

the relative risk of each asset

the total risk of each asset

The correlation between the return on two assets is calculated by dividing the covariance of returns
by the product of the standard deviations of the returns for the two assets. It will always have a
value between 1 and +1 and measures the relative relationship between the returns of a pair of
assets.

The correlation between the return on two assets _____

is calculated by dividing the covariance of returns by the product of the standard deviations of
the returns for the two assets.

will always have a value between 1.0 and +1.0.

measures the relative relationship between the returns of pair of assets.

all of the above.

Systematic risk and diversifiable risk are the two components of total risk associated with an
investment.

The two components of total risk associated with an investment are _____.
 14

covariance and correlation

short-term risk and long-term risk

variance and standard deviation

systematic risk and diversifiable risk

Investors should care only about systematic risk because they can eliminate unsystematic risk
by holding a diversified portfolio.

Investors care only about _____.

systematic risk

diversifiable risk

business-specific risk

total risk

Expected return = Risk-free rate + Beta Market Risk Premium

12.6% = [Risk-free return + 1.4 (10% Risk-free return)]
12.6% = risk-free return + 0.14 1.4 x Risk-free return
0.14 0.126 = 0.4 Risk-free return
Risk-free return = 0.35 = 3.5%.

The expected return on Bevo stock is 12.6 percent. If the expected return on the market is 10 percent
and the beta for Bevo is 1.4, then what is the risk-free rate?
 15

3.5%

2.0%

2.5%

3.0%

The Capital Asset Pricing Model (CAPM) measures the expected rate of return of an asset.

The Capital Asset Pricing Model (CAPM) measures

the realized rate of return of an asset.

the expected rate of return of an asset.

the risk-free rate of return.

the systematic risk level of an asset.

he CAPM tells us that the relation between systematic risk and return is linear.

Based on the CAPM, the relationship between the expected return of an asset and its systematic risk is
_____.

linear
 16

logarithmic

exponential

inverted

Future value: Chuck Tomkovick is planning to invest $25,000 today in a mutual

fund that will provide a return of 8 percent each year. What will be the value
of the investment in 10 years?
LO 2
Solution:
0 5 years

PV = $25,000 FV = ?

Amount invested today = PV = $25,000

Return expected from investment = i = 8%
Duration of investment = n = 10 years
Value of investment after 10 years = FV10

FV10 PV (1 i ) n $25,000 (1.08)10

$53,973.12

Future value: Your aunt is planning to invest in a bank deposit that will pay 7.5
percent interest semiannually. If she has $5,000 to invest, how much will she
have at the end of four years?
LO 2
Solution:
0 4 years

PV = $5,000 FV = ?
Amount invested today = PV = $5,000
 17

Return expected from investment = i = 7.5%

Duration of investment = n = 4 years
Frequency of compounding = m = 2
Value of investment after 4 years = FV4
mn 24
i 0.075
FV4 PV 1 $7,500 1
m 2
$7,500 (1.0375) 8
$6,712.35

5.9 Present value: Roy Gross is considering an investment that pays 7.6
percent. How much will he have to invest today so that the investment will be
worth $25,000 in six years?
LO 3
Solution:
0 6 years

PV = ? FV = $25,000

Value of investment after 6 years = FV5 = $25,000

Return expected from investment = i = 7.6%
Duration of investment = n = 6 years
Amount to be invested today = PV

FVn $25,000
PV
(1 i ) n
(1.076) 6
$16,108.92

Present value: Your brother has asked you for a loan and has promised to pay
back $7,750 at the end of three years. If you normally invest to earn 6
percent, how much will you be willing to lend to your brother?
LO 3
Solution:
0 3 years

PV = ? FV = $7,750
 18

Loan repayment amount after 3 years = FV 3 = $7,750

Return expected from investment = i = 6%
Duration of investment = n = 3 years
Amount to be invested today = PV

FVn $7,750
PV
1 i (1.06) 3
n

$6,507.05

5.15 Interest rate: You are in desperate need of cash and turn to your uncle who
has offered to lend you some money. You decide to borrow $1,300 and agree
to pay back $1,500 in two years. Alternatively, you could borrow from your
bank that is charging 6.5 percent interest. Should you go with your uncle or
the bank?
LO 2
Solution:
0 2 years

PV = $1,300 FV = $1,500

Amount to be borrowed = PV = $1,300

Amount to be paid back after 2 years = FV2 = $1,500
Interest rate on investment = i = ?
Duration of investment = n = 2 years.
Present value of investment = PV

FVn
PV
1 i n
$1,500
$1,300
(1 i ) 2
$1,500
(1 i ) 2 1.1538
$1,300
i 1.1538 1
i 7.42%

You should go with the bank borrowing.

 19

5.19 Growth rate: You decide to take advantage of the current online dating craze and
start your own Web site. You know that you have 450 people who will sign up immediately,
and through a careful marketing research and analysis you determine that membership can
grow by 27 percent in the first two years, 22 percent in year 3, and 18 percent in year 4.
How many members do you expect to have at the end of four years?

LO 4

Solution:

0 1 2 3 4 years

g1-2=27% g3=22% g4=18%

PV = 450 FV = ?

Number of Web site memberships at t = 0 = PV = 450

Expected annual growth in the next 2 years = g1-2 = 27%

Expected annual growth in years 3 = g3= 22%

Expected annual growth in years 4 = g4= 18%

Number of members in year 4 = FV4

FV4 PV(1 g1 ) 2 (1 g 3 )(1 g 4 ) 450(1.27) 2 (1.22)(1.18)

1,045 members

5.27 Multiple compounding periods: Find the present value of $3,500 under
each of the following rates and periods.
a. 8.9% compounded monthly for five years.
b. 6.6% compounded quarterly for eight years.
c. 4.3% compounded daily for four years.
d. 5.7% compounded continuously for three years.
LO 2
Solution:

0 n years

PV = ? FV = $3,500

a. Return expected from investment = i = 8.9%

 20

Duration of investment = n = 5 years

Frequency of compounding = m = 12
Present value of amount = PV

FV5 $3,500
PV mn
125
i 0.089
1 1
m 12
$3,500
$2,246.57
1.5579

b. Return expected from investment = i = 6.6%

Duration of investment = n = 8 years
Frequency of compounding = m = 4
Present Value of amount = PV

FV8 $3,500
PV mn
48
i 0.066
1 1
m 4
$3,500
$2,073.16
1.6882

c. Return expected from investment = i = 4.3%

Duration of investment = n = 4 years
Frequency of compounding = m = 365
Present Value of amount = PV

FV4 $3,500
PV mn
3654
i 0.043
1 1
m 365
$3,500
$2,946.96
1.1877

d. Return expected from investment = i = 5.7%

Duration of investment = n = 3 years
Frequency of compounding = m = Continuous
 21

Present value of amount = PV

FV3 $3,500
PV in
0.0573
e e
$3,500
$2,949.88
1.1865

5.29 You have $2,500 you want to invest in your classmates start-up business. You
believe the business idea to be great and hope to get $3,700 back at the end
of three years. If all goes according to the plan, what will be your return on
investment?
LO 2,3
Solution:
0 3 years

PV = $2,500 FV = $3,700

Amount invested in project = PV = $2,500

Expected return three years from now = FV =$3,700
To calculate the expected rate of return, we set up the future value equation.

FV3 PV (1 i ) 3
$3,700 $2,500(1 i ) 3
$3,700
(1 i ) 3 1.4800
$2,500
1
i (1.4800) 3
1 0.1396
13.96%

6.3 Future value with multiple cash flows: You are a freshman in college and
are planning a trip to Europe when you graduate from college at the end of
four years. You plan to save the following amounts starting today: $625,
$700, $700, and $750. If the account pays 5.75 percent annually, how much
will you have at the end of four years?

Solution:
0 5.75% 1 2 3 4

$625 $700 $700 $750
 22

FV4 $625(1.0575) 4 $700(1.0575) 3 $700(1.0575) 2 $750(1.0575)

$781.63 $827.83 $782.81 793.13
$3,185.40

6.5 Present value with multiple cash flows: Jeremy Fenloch borrowed from
his friend a certain amount and promised to repay him the amounts of
$1,225, $1,350, $1,500, $1,600, and $1,600 over the next five years. If the
friend normally discounts investments at 8 percent annually, how much did
Jeremy borrow?

Solution:
0 8% 1 2 3 4 5

$1,225 $1,350 $1,500
$1,600 $1,600

$1,225 $1,350 $1,500 $1,600 $1,600

PV
(1.08) (1.08) 2 (1.08) 3 (1.08) 4 (1.08) 5
$1,134.26 $1,157.41 $1,190.75 $1,176.05 $1,088.93
$5,747.40

6.7 Present value of an ordinary annuity: An investment opportunity

requires a payment of $750 for 12 years, starting a year from today. If your
required rate of return is 8 percent, what is the value of the investment
today?

Solution:
0 8% 1 2 3 11 12

$750 $750 $750 $750 $750

Annual payment = PMT = $750

No. of payments = n = 12
Required rate of return = 8%
 23

Present value of investment = PVA12

1
1 (1 i ) n
PVA n PMT
i

1
1
(1.08)12
$750 $750 7.5361
0.08
$5,652.06

6.9 Future value of an ordinary annuity: Robert Hobbes plans to invest

$25,000 a year for the next seven years in an investment that will pay him a
rate of return of 11.4 percent. He will invest at the end of each year. What is
the amount that Mr. Hobbes will have at the end of seven years?

Solution:
0 11.4% 1 2 3 6 7

$25,000 $25,000 $25,000 $25,000 $25,000

Annual investment = PMT = $25,000

No. of payments = n = 7
Investment rate of return = 11.4%
Future value of investment = FVA7

(1 i ) n 1
FVA n PMT
i
(1.114) 1
7
$25,000 $25,000 9.9044
0.114
$247,609.95

6.15 Perpetuity: Calculate the perpetuity payments for each of the following
cases:
a. $250,000 invested at 6%
b. $50,000 invested at 12%
c. $100,000 invested at 10%
 24

Solution:
a. Annual payment = PMT
Investment rate of return = i = 6%
Term of payment = Perpetuity
Present value of investment needed = PV = $250,000

PMT
PV of Perpetuit y
i
PMT PV i $250,000 0.06
$15,000

b. Annual payment = PMT

Investment rate of return = i = 12%
Term of payment = Perpetuity
Present value of investment needed = PV = $50,000

PMT
PV of Perpetuit y
i
PMT PV i $50,000 0.12
$6,000

c. Annual payment = PMT

Investment rate of return = i = 10%
Term of payment = Perpetuity
Present value of investment needed = PV = $100,000

PMT
PV of Perpetuit y
i
PMT PV i $100,000 0.10
$10,000

6.17 Effective annual rate: Cyclone Rentals borrowed $15,550 from a bank for
three years. If the quoted rate (APR) is 6.75 percent, and the compounding is
daily, what is the effective annual rate (EAR)?
 25

Solution:
Loan amount = PV = $15,550
Interest rate on loan = i = 6.75%
Frequency of compounding = m = 365
Effective annual rate = EAR
m1 365

i 0.0675
EAR 1 1 1 1
m 365
1.0698 1 7%

6.21 Present value with multiple cash flows: Carol Jenkins, a lottery winner,
will receive the following payments over the next seven years. If she can
invest her cash flows in a fund that will earn 10.5 percent annually, what is
the present value of her winnings?

1 2 3 4 5 6 7
$200,00 $250,00 $275,00 $300,0 $35000 $400,0 $550,00
0 0 0 00 0 00 0

Solution:
Expected rate of return = i = 10.5%
Investment period = n = 7 years
Future value of investment = FV

$200,000 $250,000 $275,000 $300,000 $350,000 $400,000 $550,000

FV7
(1.105)1 (1.105) 2 (1.105) 3 (1.105) 4 (1.105) 5 (1.105) 6 (1.105) 7
$180,995.48 $204,746.01 $203,819.56 $201,220.46 $212,449.96
$219,728.47 $273,417.77
$1,496,377.71

6.23 Growing annuity: Modern Energy Company owns several gas stations.
Management is looking to open a new station in the western suburbs of
Baltimore. One possibility they are evaluating is to take over a station located
at a site that has been leased from the county. The lease, originally for 99
years, currently has 73 years before expiration. The gas station generated a
net cash flow of $92,500 last year, and the current owners expect an annual
growth rate of 6.3 percent. If Modern Energy uses a discount rate of 14.5
percent to evaluate such businesses, what is the present value of this
growing annuity?
 26

Solution:
Time for lease to expire = n = 73 years
Last years net cash flow = CF0 = $92,500
Expected annual growth rate = g = 6.3%
Firms required rate of return = i = 14.5%
Expected cash flow next year = CF1 = $92,500(1 + g) = $92,500(1.063)
= $98,327.50
Present value of growing annuity = PVA n

CF1 1 g
n
$98,327.50 1.063
73

PVA n 1 1
(i g ) 1 i (0.145 0.063) 1.145
$1,199,115.85 0.995593
$1,193,831.54

6.25 Present value of an annuity due: Grant Productions has borrowed a huge
sum from the California Finance Company at a rate of 17.5 percent for a
seven-year period. The loan calls for a payment of $1,540,862.19 each year
beginning today. What is the amount borrowed by this company? Round to
the nearest dollar.

Solution:
0 17.5% 1 2 3 6 7

PMT =$1,540,862.19 at the beginning of each year

Annual payment = PMT = $1,540,862.19

Type of annuity = Annuity due
No. of payments = n = 7
Required rate of return = 17.5%
Present value of investment = PVA8
 27

1
1 (1 i ) n
PVA n PMT (1 i )
i

1
1 (1.175) 7
$1,540,862.19 (1.175) $1,540,862.19 3.8663 1.175
0.175

$6,999,999.98 $7,000,000

6.32 Gary Kornig will turn 30 years old next year and wants to retire when his is
65. So far he has saved (1) $6,950 in an IRA account in which his money is
earning 8.3 percent annually and (2) $5,000 in a money market account in
which he is earning 5.25 percent annually. Gary wants to have $1 million
when he retires. Starting next year, he plans to invest a fixed amount every
year until he retires in a mutual fund in which he expects to earn 9 percent
annually. How much will Gary have to invest every year to achieve his
savings goal?

Solution:
Investment (1)
Balance in IRA investment = PV = $6,950
Return on IRA account = i = 8.3%
Time to retirement = n = 35 years
Value of IRA at age 65 = FVIRA

FVIRA PV(1 i ) n $6,950(1.083) 35

$113,235.03

Investment (2)
Balance in money market investment = PV = $5,000
Return on money market account = i = 5.25%
Time to retirement = n = 35 years
Value of money market at age 65 = FVMMA

FVMMA PV(1 i ) n $5,000(1.0525) 35

$29,973.93
 28

Target retirement balance = $1,000,000

Future value of current savings = $113,235.03 + $29,973.93 = $143,208.96
Amount needed to reach retirement target = FVA = $856,774.04
Annual payment needed to meet target = PMT
Expected return from mutual fund = i = 9%

(1 i ) n 1
FVA PMT
i
FVA $856,791.04 $856,791.04
PMT
(1 i ) 1
n
(1.09) 35 1 215.711
i 0.09

$3,971.94

Expected returns: You have chosen biology as your college major because you
would like to be a medical doctor. However, you find that the probability of
being accepted into medical school is about 10 percent. If you are accepted
into medical school, then your starting salary when you graduate will be
$300,000 per year. However, if you are not accepted, then you would choose
to work in a zoo, where you will earn $40,000 per year. Without considering
the additional educational years or the time value of money, what is your
expected starting salary as well as the standard deviation of that starting
salary?

Solution:
E(salary) = 0.9($40,000) + (0.1) ($300,000) = $66,000
2salary = 0.9($40,000 $66,000)2 + (0.1) ($300,000 $66,000)2 =
$6,084,000,000
salary = ($6,084,000,000)1/2 = $78,000
7.5 Single-asset portfolios: Stocks A, B, and C have expected returns of 15
percent, 15 percent, and 12 percent, respectively, while their standard
deviations are 45 percent, 30 percent, and 30 percent, respectively. If you
were considering the purchase of each of these stocks as the only holding in
your portfolio, then which stock should you choose?

Solution:
Since the holding will be made in a completely undiversified portfolio, then
we can calculate the risk per unit of return for each stock, the coefficient of
variation, and choose the stock with the lowest value.
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CV(RA) = 0.45/0.15 = 3.0

CV(RB) = 0.30/0.15 = 2.0
CV(RC) = 0.30/0.12 = 2.5 ===> Choose B
7.15 Calculating the variance and standard deviation: Kate recently invested
in real estate with the intention of selling the property one year from today.
She has modeled the returns on that investment based on three economic
scenarios. She believes that if the economy stays healthy, then her
investment will generate a 30 percent return. However, if the economy
softens, as predicted, the return will be 10 percent, while the return will be
25 percent if the economy slips into a recession. If the probabilities of the
healthy, soft, and recessionary states are 0.4, 0.5, and 0.1, respectively, then
what are the expected return and the standard deviation for Kates
investment?

Solution:
E(Ri) = (0.4)(0.3) + (0.5) (0.1) + (0.1) (.25) = 0.145
2return = (0.4)(0.3 0.145)2 + (0.5) (0.1 0.145)2 + (0.1) (0.25 0.145)2
= 0.02623
return = (0.02623)1/2 = 0.16194
7.16 Calculating the variance and standard deviation: Barbara is considering
investing in a stock, and is aware that the return on that investment is
particularly sensitive to how the economy is performing. Her analysis
suggests that four states of the economy can affect the return on the
investment. Using the table of returns and probabilities below, find the
expected return and the standard deviation of the return on Barbaras
investment.
Probability Return
Boom 0.1 25.00%
Good 0.4 15.00%
Level 0.3 10.00%
Slump 0.2 -5.00%

Solution:
E(Ri) = 0.1(0.25) + (0.4) (0.15) + (0.3) (0.1) + (0.2) (o.05) = 0.105
2return = 0.1(0.25 0.105)2 + (0.4) (0.15 0.105)2 + (0.3) (0.1 0.105)2 + (0.2) (
0.5 0.105)2
= 0.00773
return = (0.00773)1/2 = 0.08789
David is going to purchase two stocks to form the initial holdings in his portfolio.
Iron stock has an expected return of 15 percent, while Copper stock has an
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expected return of 20 percent. If David plans to invest 30 percent of his funds

in Iron and the remainder in Copper, then what will be the expected return
from his portfolio? What if David invests 70 percent of his funds in Iron stock?

Solution:
Part 1: E(Rport) = (0.3)(0.15) + (0.7)(0.2) = 0.185
Part 2: E(Rport) = (0.7)(0.15) + (0.3)(0.2) = 0.165
7.27 In order to fund her retirement, Glenda requires a portfolio with an expected
return of 12 percent per year over the next 30 years. She has decided to
invest in Stocks 1, 2, and 3, with 25 percent in Stock 1, 50 percent in Stock 2,
and 25 percent in Stock 3. If Stocks 1 and 2 have expected returns of 9
percent and 10 percent per year, respectively, then what is the minimum
expected annual return for Stock 3 that will enable Glenda to achieve her
investment requirement?

Solution:
The formula for the expected return of a three-stock portfolio is:

E ( R3 asset port ) x1 E ( R1 ) x2 E ( R2 ) x3 E ( R3 )

Therefore, we can solve as in the following:

0.12 = 0.25(0.09) + 0.5(0.1) + 0.25E(R 3)
0.19 = E(R3)