Question

Your portfolio has provided you with returns of 26.3 percent, 19.8 percent, 4.6 percent, and 7.9 percent over the past four years, respectively. What is the geometric average return.

A. 8.06 percent

B. 9.27 percent

C. 10.25 percent

D. 11.71 percent

E. 14.31 percent

____________

The common stock of Detroit Engines has a beta of 1.34 and a standard deviation of 11.4 percent. The market rate of return is 11.5 percent and the risk-free rate is 3 percent. What is the firm’s cost of equity?

A. 10.05 percent

B. 12.98 percent

C. 14.39 percent

D. 15.50 percent

E. 15.67 percent

Answer 1

Solution to PART 1

Geometric Average Return = [(1 + 0.2630) x (1 + 0.1980) x (1 + 0.0460) x (1 + 0.0790)]^1/4 – 1

= (1.7077068) ^1/4 – 1

= 1.14315027 – 1

= 0.14315027 or

= 14.31%

“Hence, Geometric Average Return would be E. 14.31 percent”

Solution to PART 2

As per Capital Asset Pricing Model [CAPM], The Cost of Equity is computed by using the following equation

Cost of Equity = Risk-free Rate + Beta[Market Rate of Return – Risk-free Rate]

= 3.00% + 1.34(11.50% - 3.00%)

= 3.00% + (1.34 x 8.50%)

= 3.00% + 11.39%

= 14.39%

“Hence, the Cost of Equity will be C. 14.39 percent“