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Finance: Considering Expect Return

1. Suppose the risk free return is 4% and the market portfolio has an expected return of 10% and a volatility of 16%. Johnson and Johnson Corporation (Ticker JNJ) stock has a 20% volatility and a correlation with the market of 0.06.
a) What is Johnson and Johnson's beta with respect to the market?
b) Under the CAPM assumptions, what is its expected return?

2. Global Pistons (GP) has a common stock with a market value of $200 million and debt with a value of $100 million. Investors expect a 15% return on the stock and a 6% return on the debt. Assume perfect capital markets.
a) Suppose GP issues $100 million of new stock to buy back the debt. What is the expected return of the stock after this transaction?
b) Suppose instead GP issues $50 million of new debt to repurchase stock.
i) If the risk of the debt does not change, what is the expected return of the stock after this transaction?
ii) If the risk of the debt increases, would the expected return of the stock be higher or lower than in part (i)?

Solution Preview

1. a) What is Johnson and Johnson's beta with respect to the market?
Beta = Correlation (market, Stock)*volatility of stock/volatility of market = 0.06*20%/16%=0.075
b) Under the CAPM assumptions, what is its expected return?
Re=Rf+Beta*(Rm-Rf) = 4%+0.075*(10%-4%)=4.45%

2. a) Suppose GP issues $100 million of new stock to buy back the debt. What is the expected return of the stock after this ...

Solution Summary

This solution is comprised of a detailed, step by step response which clearly indicates how to solve for the expected rate of return for the two different companies in question. All calculations and formulas are provided.

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