Question

You plan to invest in the Kish Hedge Fund, which has total capital of $500 million invested in five stocks:

Stock	Investment	Stock's Beta Coefficient
A	$160 million	0.7
B	120 million	1.1
C	80 million	1.8
D	80 million	1.0
E	60 million	1.8

Kish's beta coefficient can be found as a weighted average of its stocks' betas. The risk-free rate is 6%, and you believe the following probability distribution for future market returns is realistic:

Probability	Market Return
0.1	-27	%
0.2	0
0.4	14
0.2	29
0.1	55

1. What is the equation for the Security Market Line (SML)? (Hint: First determine the expected market return.)
   1. r_i = 9.8% + (10.1%)b_i
   2. r_i = 6.0% + (8.2%)b_i
   3. r_i = 7.2% + (7.4%)b_i
   4. r_i = 6.0% + (10.1%)b_i
   5. r_i = 9.8% + (8.2%)b_i

   -Select-IIIIIIIVVItem 1

2. Calculate Kish's required rate of return. Do not round intermediate calculations. Round your answer to two decimal places.

     %

3. Suppose Rick Kish, the president, receives a proposal from a company seeking new capital. The amount needed to take a position in the stock is $50 million, it has an expected return of 14%, and its estimated beta is 1.5. Should Kish invest in the new company?

   The new stock -Select-should notshouldItem 3  be purchased.

   At what expected rate of return should Kish be indifferent to purchasing the stock? Round your answer to two decimal places.

     

Answer 1

Portfolio beta is equal to weighted average beta

= 0.7*160/500 + 1.1*120/500 + 1.8*80/500 + 1*80/500 + 1.8*60/500

= 1.152

Expected Market return = 0.1*-27% + 0.2*0% + 0.4*14% + 0.2*29% + 0.1*55%

= 14.2%

SML Equation is : Stock return = Risk free rate + beta*(Market return – risk free rate)

= 6% + b*(8.2%)

i.e. II

b.Required rate of return = 6% + 1.152*8.2%

= 15.4464% i.e. 15.45%

c.Rate of return required = 6% + 1.5*8.2%

= 18.3%

SHOULD NOT be purchased as return is lower

Indifference expected rate of return = 18.3%