Question

V. Douglas Keel, a financial analyst for Orange Industries, wishes to estimate the rate of return for two similar-risk investments, X and Y. Douglas’s research indicates that the immediate past returns will serve as reasonable estimates of future returns. A year earlier, investment X had a market value of $20,000; investment Y had a market value of $55,000. During the year, investment X gener- ated cash flow of $1,500 and investment Y generated cash flow of $6,800. The current market values of investments X and Y are $21,000 and $55,000, respectively. a) Calculate the expected rate of return on investments X and Y using the most recent year’s data. 
 b) Assuming that the two investments are equally risky, which one should Douglas recommend? Why?
 VI. You have been asked for your advice in selecting a portfolio of assets and have been given the following data: You have been told that you can create two portfolios—one consisting of assets A and B and the other consisting of assets A and C—by investing equal proportions (50%) in each of the two component assets. a) Whatistheexpectedreturnforeachassetoverthe3-yearperiod?
 b) Whatisthestandarddeviationforeachasset’sreturn?
 c) Whatistheexpectedreturnforeachofthetwoportfolios?
 d) How would you characterize the correlations of returns of the two assets making up each of the two portfolios identified in part c? 
 e) Whatisthestandarddeviationforeachportfolio?
 f) Which portfolio do you recommend? Why 


Answer 1

You have asked two unrelated questions, that also with multiple sub parts. I will address all the sub parts of the first question.

Q - V

a) Calculate the expected rate of return on investments X and Y using the most recent year’s data.

the expected rate of return on investments X = [P(X)_today + Intermediate cash flow - P(X)₀] / P(X)₀

= (21,000 + 1,500 - 20,000) / 20,000 = 12.50%

the expected rate of return on investments Y = [P(Y)_today + Intermediate cash flow - P(Y)₀] / P(Y)₀

= (55,000 + 6,800 - 55,000) / 55,000 = 12.36%

b) Assuming that the two investments are equally risky, which one should Douglas recommend? Why?

If the level of risk is same, the preferred investment is the one with higher return. Hence, Douglas should recommend Investment X.