Question

1.Joe Jones, Inc. has a beta of .85. The risk-free rate is 5% and the expected rate of return on the market portfolio is 10%.

a. Compute the required return for Joe Jones using the security market line (SML) equation.

b. What is "beta?" Under what rationale is beta an appropriate measure of risk.

2. A firm's return on assets (ROA) decreased during a year in which its net profit margin and its return on equity (ROE) increased. Explain what must have happened to the firm's asset turnover and equity multiplier.

Answer 1

Q1 -

a.

Rf =	5%
Rm-Rf =	(10-5) =	5%
Beta =	0.85
Re =	Rf + (Rm-Rf) x Beta
=	5 + (5 x 0.85)
=	9.25

b. Beta is a measure of risk, it shows how much does a stock changes with change in market return.

It is useful if the investor is looking forword to buy/sell in a short period of time.

Q2. Since the ROA is decreased but the ROE and profit increase that can be possible if -

The company has purchased a high value of assets this year because of which the the base of ROA increase more then the profit.

Asset turnover = Sales/ Total assets

Since the increase in profit is lower then increase in assets the ratio will decrease.

Equity Multiplier = Assets/Equity

Assets increase and equity either remain same or increase is lower then the profit therefore the ratio will increase.