Question

You have the following information on two securities in which you have invested money:

Security Expected Return

Xerox 15% Kodak 12%

Standard deviation

4.5% 3.8%

Beta %Invested

1.20 35% 0.98 65%

The rate of return on the market portfolio is 17% and the risk-free rate of return is 7.5%.

a) Compute the expected return on the portfolio.

b) Compute the beta of the portfolio.

c) Compute the required rate of return on the portfolio using the CAPM.

d) Is the portfolio correctly valued? Explain.

e) Compute the required rate of return on each of the two stocks.

f) Are the two stocks correctly valued? Explain.

g) If instead of the specified weights, you invested 45% in the Xerox stock, and the remaining

money in the Kodak stock, compute the expected return and beta on this new portfolio?

Answer 1

a)

epected return on portfolio = weighted average return

= (0.35*15%) + (0.65*12%)

= 13.05%

b)

beta of portfolio = weighted average beta

= (0.35*1.20) + (0.65*0.98)

= 1.057

c)

as per CAPM required return = risk free rate + beta*(market return - risk free rate)

= 7.5% + 1.057*(17% - 7.5%)

= 17.54%(rounded to two decimals)

d)

CAPM return = 17.54%

expected portfolio return calculated in (a) = 13.05%

since both are not equal portfolio is not valued correctly

e)

using the CAPM formula above

required return on xerox = 7.5% + 1.20*(17% - 7.5%)

= 18.90%

required return on Kodak = 7.5% + 0.98*(17% - 7.5%)

= 16.81%

f)

since CAPM return and expected returns are not equal they are not correctly valued.

g)

expected return = (0.45*15%) + (0.55*12%)

= 13.35%

new beta = (0.45*1.20) + (0.55*0.98)

= 1.079