# Financial Management: Rate of return, cost of equity, expected returns, yield

6. You have the following data on three stocks shown below. You decide to use the data on these stocks to form an index, and you want to find the average earned rate of return for 2008 on your index. If you follow the averaging procedure used to calculate the S&P 500 Index return, what would your index's rate of return be? Hints: Rates of return are based on beginning-of-year prices, and the S&P Index is weighted by market values of the companies in the index.

Stock Dividend Beginning Price Ending Price Shares

A $ 1.50 $ 30.00 $ 32.00 5.00

B $ 2.00 $ 28.50 $ 27.00 4.50

C $ 0.75 $ 20.00 $ 24.00 19.50

7. Scanlon Inc.'s CFO hired you as a consultant to help her estimate the cost of capital. You have been provided with the following data: rRF = 4.10%; RPM = 5.25%; and b = 1.15. Based on the CAPM approach, what is the cost of equity from retained earnings?

8. A highly risk-averse investor is considering adding one additional stock to a 3-stock portfolio, to form a 4-stock portfolio. The three stocks currently held all have b = 1.0, and they are perfectly positively correlated with the market. Potential new Stocks A and B both have expected returns of 15%, are in equilibrium, and are equally correlated with the market, with r = 0.75. However, Stock A's standard deviation of returns is 12% versus 8% for Stock B. Which stock should this investor add to his or her portfolio, or does the choice not matter?

Answer

Either A or B, i.e., the investor should be indifferent between the two.

Stock A.

Stock B.

Neither A nor B, as neither has a return sufficient to compensate for risk.

Add A, since its beta must be lower.

9. If D = $1.25, g (which is constant) = 4.7%, and P = $29.00, what is the stock's expected dividend yield for the coming year?

10. Dothan Inc.'s stock has a 25% chance of producing a 17% return, a 50% chance of producing a 12% return, and a 25% chance of producing a -18% return. What is the firm's expected rate of return?

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#### Solution Preview

6. You have the following data on three stocks shown below. You decide to use the data on these stocks to form an index, and you want to find the average earned rate of return for 2008 on your index. If you follow the averaging procedure used to calculate the S&P 500 Index return, what would your index's rate of return be? Hints: Rates of return are based on beginning-of-year prices, and the S&P Index is weighted by market values of the companies in the index.

Stock Dividend Beginning Price Ending Price Shares

A $ 1.50 $ 30.00 $ 32.00 5.00

B $ 2.00 $ 28.50 $ 27.00 4.50

C $ 0.75 $ 20.00 $ 24.00 19.50

Return = (Ending Price – ...

#### Solution Summary

The solution explains some finance questions relating to rate of return, cost of equity, expected returns, yield