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	1.7
D	80 million	1.0
E	60 million	1.6

Kish's beta coefficient can be found as a weighted average of its stocks' betas. The risk-free rate is 3%, and you believe the following probability distribution for future market returns is realistic:

Probability	Market Return
0.1	-26	%
0.2	0
0.4	11
0.2	32
0.1	52

1. What is the equation for the Security Market Line (SML)? (Hint: First determine the expected market return.)
   1. r_i = 6.4% + (10.0%)b_i
   2. r_i = 3.0% + (10.4%)b_i
   3. r_i = 3.6% + (9.9%)b_i
   4. r_i = 3.0% + (10.0%)b_i
   5. r_i = 6.4% + (10.4%)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 1.4. 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

Solution :-

Expected Market Return =

= ( 0.10 * - 26% ) + ( 0.20 * 0% ) + ( 0.40 * 11% ) + ( 0.20 * 32% ) + ( 0.10 * 52% )

= 13.4%

Portfolio Beta =

Total Investment in Portfolio = 160 + 120 + 80 + 80 + 60 = 500 million

Now Portfolio Beta = ( 0.70 * 160 / 500 ) + ( 1.1 * 120 / 500 ) + ( 1.7 * 80 / 500 ) + ( 1 * 80 / 500 ) + ( 1.6 * 80 / 500 )

= 1.112

Risk Free Rate Given = 3.0%

Now Security Market Line = Rf + Beta ( Rm - Rf )

= 3% + Beta * ( 13.4% - 3.0% )

= 3.0% + Beta * 10.4%

Therefore Correct answer is (ii)

(b)

Now Portfolio Beta = 1.112

Now Required Return of Kish = 3.0% + 1.112 * ( 13.4% - 3.0% )

= 14.56%

(C)

Beta of Rick Investment = 1.40

Therefore Expected Return = 3% + 1.40 * ( 13.4% - 3.0% ) = 17.56%

Risk Should not accept the project as it gives only 14% and at beta 1.4 Expected return is 17.56%