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Module 1 – Case Present Value and the Risk/Return Trade-Off Assignment Overview

Module 1 – Case

Present Value and the Risk/Return Trade-Off

Assignment Overview

For this assignment, make sure to first carefully review all of the required readings about present value, future value, risk and return, and the CAPM. Once you are relatively comfortable with these concepts, try working through some of the examples in the background readings and try computing the answers on your own. Once you are confident you both understand the concepts and the computational steps, complete the assignment below.

Case Assignment

Present your answers to the problem below in a Word document, and also upload an Excel file with your computations. Excel is required for Questions 2 and 3. Excel is optional for Questions 1 and 4, but you are required to show your steps for all quantitative problems. Even if you get the answer wrong, you can still get partial credit if you show your work.

  1. Calculate the following:
    1. Suppose you wish to raise some money for your favorite local charity. This charity needs $50,000 a year to run its operation and you want to make sure that it is ensured an annual payment of this amount from now on for every year in the foreseeable future. Given an interest rate of 5%, how much would you have to fund this perpetuity to guarantee the charity a payment of $50,000 per year?
    2. You decide to put $1,000 in a new bank account and don’t plan to withdraw the money for 10 years. If your bank does continuous compounding and the interest rate is 1%, what will be the value of this bank account in 10 years?
  2. Suppose you won the lottery but not all of your winnings will come in one year. Instead, you will get a series of annual payments over the next five years. The table below tells you what your payment will be every year for the next five years. Use the information in the table to make the following computations:
    1. The present and future value of your lottery ticket if the interest rate is 8%
    2. The present and future value of your lottery ticket if the interest rate is 10%
Year Payment
1 5000
2 6000
3 7000
4 8000
5 9000
  1. The table below gives the probability of different returns for three different assets. Using this table, calculate the following:
    1. The expected return of each asset
    2. The standard deviation of returns of each asset
    3. The coefficient of variation of each asset
    4. Based on your answers to B) and C) above, which asset has the highest total risk and highest relative risk?
Asset A Asset B Asset C
Probability Return Probability Return Probability Return
0.3 5 0.1 25 0.1 4
0.4 8 0.3 20 0.8 5
0.3 9 0.5 15 0.1 6
0.1 14
  1. Suppose the market return is 8%, the risk-free rate is 1% and the beta for a given stock is 1.2. Answer the following questions based on this information:
    1. What is the required return for this stock?
    2. If the beta increases by 50% (but risk-free rate remains 1%), what will be the new required return for the stock? What is the percentage-wise change in required return compared to your answer to A) above?
    3. If the market return increases by 50% (but beta remains at 1.2), what will be the new required return for the stock? What is the percentage-wise change in required return compared to your answer to A) above?
  2. Suppose there are three different companies. The first one, Trendy Tech Inc., has investors who are “fair-weather friends.” When the stock market is going up, everybody wants to invest in Trendy Tech, but as soon as the market goes down everyone jumps ships and sells their shares. The second company is Oily Oil Inc. Oily’s stock price seems to depend only on the price of oil and nothing else. Finally, there is Conglomerated Conglomerate Inc. Conglomerated is a giant company with holdings in almost every industry imaginable—from cell phones to grocery stores and even amusement parks. Based on this information, which company would you think has the highest beta? The lowest beta? Which one do you think has a beta closest to 1?

Module 1 – SLP

Present Value and the Risk/Return Trade-Off

For the SLP this session, you will be taking a close look at a company of your choice. You are free to choose any company you want as long as it is publicly traded on one of the major stock market exchanges such as NYSE or NASDAQ. This could be a company that you personally are interested in investing in, or a company whose product you buy, or one that you have read about in the news recently and would like to know more about. Do some research on this company, including recent articles. Also, look up the company on Google Finance. This will give you a wealth of information including stock prices over the last month, year, five years, etc., along with other information such as the beta or whether or not the company is profitable.

 

Once you have chosen a company and have done some initial research on it, write a 2- to 3-page paper discussing the following items:

  1. Give a brief description of the company and why you find it interesting.
  2. What is the beta of this company’s stock? Based on the magnitude of the beta, do you think it is low risk, high risk, or somewhere in between?
  3. Now look at recent stock price movements. What is the highest price the stock has been over the last year? The lowest price over the last year? Look at the five-year pattern as well. Based on what you see, what does this tell you about the riskiness of the stock?
  4. Look at some other companies in the same industry as your chosen company. How do they compare in terms of beta and other measures of riskiness? Would you prefer to invest in your chosen company, or do some of its competitors seem like a better bet?
Module 1 – Case Present Value and the Risk/Return Trade-Off Assignment Overview
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