PART A
Question 1
Expected return is forward-looking since it indicates what investors would expect from their investment as compensation for the risk they are exposed to. Investors must determine the risk level of investment and decide whether to invest their money or not. The investors must be able to predict the reactions of the market and the expected return of the market (Ross, Westerfield & Jordan, 2016). The concept, therefore, relies heavily on prediction as opposed to historical data to determine whether an investment should be pursued or not. Investors analyze internal and external environment and the general economic conditions to determine whether an investment will realize the expected returns.
Expected return focuses more on the future and tries to determine what investors are likely to get for their investment. A risky project, for example, should have higher returns to compensate for the high risk. A low-risk project, on the other hand, can have a low expected return since investors are not afraid of losing their investment. The risk level of investment, therefore, determines the expected return of an investment and the appeal such an investment has on the investors (Gitman & Zutter, 2015). If the investors can predict with certainty the expected return, they are likely to select projects that met their risk profiles.
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Expected return, therefore, focuses on the future and what investment is likely to yield. It only relies on the historical data to establish the trend and to predict future returns. An investor, for example, can invest in treasury bills if they are risk-averse (Gitman & Zutter, 2015). However, a risk seeker, on the other hand, is willing to take risks by enduring large swings in exchange for high returns.
Question 2
Challenges ranging from forecasting methods, accuracy and the general environment arise from the use of expected returns. Expected returns heavily rely on the ability to make accurate predictions of the expected risk and the future returns of a project. Any inaccuracies in the predictions can lead to uninformed decisions that can have significant effects on the value of an investment (Gitman & Zutter, 2015). The process of developing forecasts is not only challenging but also one that requires the expertise and experience for establishing forecasts that reflect a true picture of the environment.
An individual responsible for developing the predictions for expected returns must be aware of the factors that adversely affect future returns. They must consider the effect of the external environment, the general outlook of the business environment and the performance of the industry (Ross, Westerfield & Jordan, 2016). The ability to select the most appropriate forecasting methods can therefore significantly affects the expected return.
The accuracy of the predictions also affects the expected return. Accurate forecasts lead to informed decisions since the expected return can be determined objectively thus the investors can make informed decisions on the best course of action (Ross, Westerfield & Jordan, 2016). The accuracy of such predictions can have a significant influence on investment depending on the risk profile of an investor.
The use of expected returns can be affected by a sudden change in the environment. Political, legal, economic and technological changes can significantly affect expected returns. Such factors can increase or reduce the returns of investment and therefore contribute to uncertainties and affects the decisions of an investor (Weaver & Weston, 2001; Sherman, 2011). External shocks can reduce the expected returns and the investor will lose their money and therefore will not gain from such an investment.
Question 3
Differences in the allocation between risk-free security and the market portfolio can have an effect on the level of market risk. The desired level of market risk depends on the risk-free security and the risk premium associated with a market portfolio. Investors determine the risk premium of an investment depending on how risky such an investment is. A portfolio with fewer risks is likely to have a lower premium since investors are assured of their returns. Risk-free securities like government bonds are guaranteed of a pre-determined return and therefore the level of risk is lower compared to investments like shares that fluctuate. However, risky portfolios attract higher market premiums which will affect the level of the market risk (Jordan, Westerfield & Ross, 2011). A risk-averse investor would prefer an investment whose return is guaranteed even though the return is lower. A risk seeker, on the other hand, would invest in high return investments with high risks thus the market risk for such an investor is likely to be high compared to one who selects a low-risk portfolio.
PART B: Problems
Question 4
| Economic State | Probability | Percentage of Return | Returns |
| Fast Growth | 0.10 | 60 | 0.06 |
| Slow Growth | 0.50 | 30 | 0.15 |
| Recession | 0.40 | -23 | -0.092 |
| Expected return | 11.8% | ||
Expected return = sum of the returns for each economic state
= (0.10*60%) + (0.50*30%) + (0.40*-23)
= 6% +15% -9.2% = 11.8%
Require return = risk free rate + risk premium
=7% + 4%
= 11%
S&P 500 Index = 14.8%
T-bill return =5.6%
Market risk premium = S&P Index – T-bill
=14.8% - 5.6%
=7.24%
Conglomco expected return using CAPM can be calculated as follows
R=rf + ᵝ(rm – rf)
The risk free rate is 5% and the return of the market is 12% the beta is 0.32 so the expected return r can be determined as follows
R = 5% +0.32(12% - 5%)
R = 7.24%
Beta of a portfolio with conglomco, Supercorp and Megaorg stocks = beta of the stock * weight in the portfolio
Beta = 3.9*35% + 1.7*25% + 0.3*40%
=1.365 +0.425 + 0.12
= 1.91
References
Gitman, L., & Zutter, C. (2015). Principles of managerial finance (14th ed.). Pearson.
Jordan, B., Westerfield, R. & Ross, S. (2011). Corporate finance essentials. New York: McGraw-Hill Irwin.
Ross, S., Westerfield, R. & Jordan, B. (2016). Fundamentals of corporate finance. (11th ed.) New York: McGraw-Hill Higher Education.
Sherman, E. H. (2011). Finance and accounting for nonfinancial managers (3rd ed.). New York, NY: American Management Association.
Weaver, S. C., & Weston, J. F. (2001). Finance and accounting for nonfinancial managers. New York, NY: McGraw-Hill.
