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Investment Fundamentals and Portfolio Management questions

1. John Smith has been reviewing the stock of ABC. John has estimated that the stock will have the following possible returns and probabilities:

Return Probability

-0.15 0.10
-0.05 0.20
0.05 0.35
0.15 0.25
0.25 0.10

a. Compute the expected return on ABC stock.
b. Compute the standard deviation of returns on ABC.

2. A stock sells for $67 per share and pays a quarterly dividend of $0.50. One year later, the stock sells for $76.

a. Compute the holding-period return on this investment.
b. Compute the holding period return assuming that the investor could buy this stock borrowing half of the purchase price at 12 percent per annum interest.
c. Compute the holding period return (including the information from part b) if the investor pays a commission of $0.40 per share on both the purchase and sale transaction.

3. You open a margin account with a brokerage firm. The initial margin requirement is 50 percent, and the maintenance margin requirement is 25 percent. You purchase 100 shares of a stock selling for $40 per share.

a. How much money do you need to have in your margin account to make this purchase? (Ignore commissions.)
b. What is the amount of your margin loan from the broker?
c. If the stock falls to $32, what is the margin in the account?
d. At what stock price will you receive a margin call?

4. What is the market price per share of Whopie, Inc. if the firm had net income of $200,000, earnings per share of $2.70, total equity of $800,000, and a market to book value ratio of 1.5?

5. The companies in the electrical parts industry have an average earnings multiple of 16. John's Parts, Inc. manufactures electrical parts, and you have forecast that the company will earn $3.60 per share and its stock will sell at the industry average multiple 3 years from now. Estimate the value of John's Parts stock in 3 years. If the required rate of return is 14 percent, what is the present value of John's Parts stock?

6. Tom Jones has identified the following securities for a portfolio:

Security Amount Invested Expected Return Beta

A $25,000 0.05 1.4
B $35,000 0.11 0.1
C $5,000 0.15 0.5
D $35,000 0.01 1.9

Compute the expected return of the portfolio. Compute the beta of the portfolio.

7. The Elvis Alive Corporation, makers of Elvis memorabilia, has a beta of 2.35. The return on the market portfolio is 13%, and the risk-free rate is 7%. According to CAPM, what is the risk premium on a stock with a beta of 1.0?

8. Discuss the 3 forms of market efficiency and the evidence for each form of market efficiency.

9. Compute the value of the following options at expiration:

a. An IBM July 90 call when IBM sells for $98
b. An Eastman Kodak April 25 call with the stock priced at $19
c. A Wall-Mart January 60 put with Wal-Mart stock selling for $48
d. A Pfizer October 35 put with the stock priced at $42.

Solution Preview

Please see attached file for complete answers

1. John Smith has been reviewing the stock of ABC. John has estimated that the stock will have the following possible returns and probabilities:

Return Probability

-0.15 0.1
-0.05 0.2
0.05 0.35
0.15 0.25
0.25 0.1

a. Compute the expected return on ABC stock. 0.055
b. Compute the standard deviation of returns on ABC. 0.1117

(See calculations below)

ABC
return Probability return x Probability Difference from mean, i.e.0.055 Difference 2 Prob x Difference 2
-0.15 0.1 -0.0150 -0.2050 0.042025 0.0042025
=-0.15x0.1 =-0.15-0.055 =-0.205^2 =0.1x0.042025
-0.05 0.2 -0.0100 -0.1050 0.011025 0.0022050
0.05 0.35 0.0175 -0.0050 0.000025 0.0000087
0.15 0.25 0.0375 0.0950 0.009025 0.0022563
0.25 0.1 0.0250 0.1950 0.038025 0.0038025
Total 1.00 0.0550 0.012475

Expected return= 0.0550
Variance= 0.012475
Standard deviation of returns =square root of Variance= 0.1117 =square root of 0.012475

2. A stock sells for $67 per share and pays a quarterly dividend of $0.50. One year later, the stock sells for $76.

a. Compute the holding-period return on this investment.

Dividend income = 4 x $0.50= $2.00
Capital gains= $76- $67= $9.00
$11.00

Initial investment= $67.00

Therefore holding period return= 16.42% =11/67

b. Compute the holding period return assuming that the investor could buy this stock borrowing half of the purchase price at 12 percent per annum interest.

Amount borrowed=$67/2= $33.50
Interest @ 12% = $4.02 =0.12x33.5

Dividend income = 4 x $0.50= $2.00
Capital gains= $76- $67= $9.00
Less interest expense= -$4.02
$6.98

Initial investment= $33.50 (the remaining is provided by borrowing)

Therefore holding period return= 20.84% =6.98/33.5

c. Compute the holding period return (including the information from part b) if the investor pays a commission of $0.40 per share on both the purchase and sale transaction.

Amount borrowed=$67/2= $33.50
Interest @ 12% = $4.02 =0.12x33.5

Dividend income = 4 x $0.50= $2.00
Capital gains= $76- $67= $9.00
Less commision= 2 x $0.40 -$0.80
Less interest expense= -$4.02
$6.18

Initial investment= $33.50 (the remaining is provided by borrowing)

Therefore holding period return= 18.45% =6.18/33.5

3. You open a margin account with a brokerage firm. The initial margin requirement is ...

Solution Summary

Answer to 9 Investment Fundamentals and Portfolio Management questions dealing with return on stock, holding-period return on investment, margin account, market price per share, value of stock, expected return of the portfolio, beta of the portfolio, CAPM, value of options at expiration.

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