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Textbook: Essentials of Investments

Chapter 7 (1, 2, 3, 6, 16, 18, and 32)

1. Which of the following statements about the security market line (SML) are true?
a. The SML provides a benchmark for evaluating expected investment performance.
b. The SML leads all investors to invest in the same portfolio of risky assets.
c. The SML is a graphic representation of the relationship between expected return
and beta.
d. Properly valued assets plot exactly on the SML.

2. Karen Kay, a portfolio manager at Collins Asset Management, is using the capital asset
pricing model for making recommendations to her clients. Her research department has
developed the information shown in the following exhibit.

Forecasted Returns, Standard Deviations, and Betas
Forecasted Return Standard Deviation Beta
Stock X 14.0% 36% 0.8
Stock Y 17.0 25 1.5
Market index 14.0 15 1.0
Risk-free rate 5.0

3. What must be the beta of a portfolio with E ( r P ) _ 20%, if r f _ 5% and E ( r M ) _ 15%?

6. Are the following statements true or false? Explain.
a. Stocks with a beta of zero offer an expected rate of return of zero.
b. The CAPM implies that investors require a higher return to hold highly volatile
securities.
c. You can construct a portfolio with a beta of 0.75 by investing 0.75 of the budget in
T-bills and the remainder in the market portfolio.

In Problems 16-18 below, assume the risk-free rate is 8% and the expected rate of
return on the market is 18%.
16. A share of stock is now selling for $100. It will pay a dividend of $9 per share at the end
of the year. Its beta is 1.0. What do investors expect the stock to sell for at the end of the
year?

18. A stock has an expected return of 6%. What is its beta?

32. The security market line depicts:
a. A security's expected return as a function of its systematic risk.
b. The market portfolio as the optimal portfolio of risky securities.
c. The relationship between a security's return and the return on an index.
d. The complete portfolio as a combination of the market portfolio and the risk-free
asset.

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The solution explains some investment questions relating to SML, CAPM, Beta and expected rate of return

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Question about Investment analysis

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The largest retail brokerage firm in the US, America's Best Investment Company, has hired you to advise clients on investments and to meet their individual financial objectives. Your first client, Dr. Tyrone Washington, is a wealthy, young doctor with little experience in financial decision making and investments.

You want to build him a good foundation with basic investment fundamentals because Dr. Washington has little investment experience. You want to ensure his understanding of the basics of investment vehicles, how they make or lose money, and the risk associated with investing.

You want to discuss with Dr. Washington how to build an optimal portfolio of investments. Although Dr. Washington is looking at different investments, specifically stocks and bonds, he has yet to learn how to take all of his investments and build a portfolio that will meet his financial objectives.

Given the importance of analysis, you decide to focus Dr. Washington's training in investment analysis about how to gather and analyze investment information, appreciate his own risk profile, and make investment decisions that are consistent with his level of risk tolerance.

PROBLEM:

Given that Dr. Washington wants to make stocks a major part of his investment portfolio, you decide to focus on how to analyze stocks. You decide to use ABC Company, one of the largest industrial companies in the US, to demonstrate how to analyze stocks.

Dr. Washington is busy this week, so he asks you to send him an e-mail. Compose an e-mail that explains the following information for ABC Company, which is a publicly traded company that trades on the NYSE.

52-week range: Hi 75 Lo 35
Current stock price: 50
Dividend Yield: 2.75%
Dividend per share: 1.375
P/E ratio: 20
Earnings per share
Shares outstanding: 100 million
Market capitalization

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