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Chapter 4: Q10BP (page 441)

Tim Trepid is highly risk-averse while Mike Macho actually enjoys taking a risk.

a. Which one of the four investments should Tim choose? Compute coefficients of variation to help you in your choice.

Investments

Returns:

Expected Value

Standard Deviation

Buy stocks ..................................... \( 9,140 \) 6,140

Buy bonds ..................................... 7,680 2,560

Buy commodity futures ................. 19,100 26,700

Buy options ................................... 17,700 18,200

b. Which one of the four investments should Mike choose?

Short Answer

Expert verified

a. Coefficient of variation


Buy stocks

0.6718

Buy bonds

0.333

Buy commodity futures

1.3980

Buy options

1.0282

Thus, Tim shall buy bonds because lower the coefficient of variation the better his risk- return trade off.

b. Mike should choose buying commodity futures.

Step by step solution

01

a.  Computation of coefficient of variation

CoefficientofvariationBuystocks=StandarddeviationExpectedvalue=61409140=0.6718

02

a. Computation of coefficient of variation

CoefficientofvariationBuybonds=StandarddeviationExpectedsales=25607680=0.333

03

a. Computation of coefficient of variation

CoefficientofvariationBuycommodityfutures=StandarddeviationExpectedsales=2670019100=1.3980

04

a. Computation of coefficient of variation

CoefficientofvariationBuyoptions=StandarddeviationExpectedsales=1820017700=1.0282

05

b. Investment decision

As Mike enjoys to take high risk, he will opt for purchase of commodity futures. The coefficient of variation of commodity future is higher in comparison to other options that means risk is comparatively higher.

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Most popular questions from this chapter

Question:Justin Cement Company has had the following pattern of earnings per share over the last five years:

Year Earnings per Share

20X1 ................... $5.00

20X2 ................... 5.30

20X3 ................... 5.62

20X4 ................... 5.96

20X5 ................... 6.32

The earnings per share have grown at a constant rate (on a rounded basis) and will continue to do so in the future. Dividends represent 40 percent of earnings.

Project earnings and dividends for the next year (20X6).

If the required rate of return (Ke) is 13 percent, what is the anticipated stock price (P0) at the beginning of 20X6?

Question:Beasley Ball Bearings paid a \(4 dividend last year. The dividend is expected to grow at a constant rate of 2 percent over the next four years. The required rate of return is 15 percent (this will also serve as the discount rate in this problem). Round all values to three places to the right of the decimal point where appropriate.

a. Compute the anticipated value of the dividends for the next four years. That is, compute D1, D2, D3, and D4; for example, D1 is \)4.08 (\(4 3 1.02).

b. Discount each of these dividends back to present at a discount rate of 15 percent and then sum them.

c. Compute the price of the stock at the end of the fourth year (P4). P4 5 D5 ______ Ke 2 g (D5 is equal to D4 times 1.02.)

d. After you have computed P4, discount it back to the present at a discount rate of 15 percent for four years.

e. Add together the answers in part b and part d to get P0, the current value of the stock. This answer represents the present value of the four periods ofdividends, plus the present value of the price of the stock after four periods (which in turn represents the value of all future dividends).

f. Use Formula 10-8 to show that it will provide approximately the same answer as part e. P0 5 D1 ______ Ke 2 g For Formula 10-8, use D1 5 \)4.08, Ke 5 15 percent, and g 5 2 percent. (The slight difference between the answers to part e and part f is due to rounding.)

g. If current EPS were equal to $4.98 and the P/E ratio is 1.2 times higher than the industry average of 6, what would the stock price be?

h. By what dollar amount is the stock price in part g different from the stock price in part f?

i. In regard to the stock price in part f, indicate which direction it would move if (1) D1 increases, (2) Ke increases, and (3) g increases

How much would you have to invest today to receive c. $6,000 each year for 10 years at 9 percent?

Christy Reed made a \(2,000 deposit in her savings account on her 21st birthday, and she has made another \)2,000 deposit on every birthday since then. Her account earns 7 percent compounded annually. How much will she have in the account after she makes the deposit on her 32nd birthday?

If you invest $9,000 today, how much will you have

d. In 25 years at 14 percent (compounded semiannually)?
See all solutions

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