Fin Aw7

Finance A
November 11, 2021 (Week 7)

Prof. Tatsuo KUROGI
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Summary High Performers
Submission Scores Ong Ching-Yuen
Duong Phuong Thao
High 50 Katariina Jokinen
On time 37 Low 32 50
La Quang Minh
Average Yawen Liu
Late* 5 44.0 Mo Wei
Non 1 0
Total 43 students; Full mark 50; *5 points deducted for late submission
If you want to know your score, please send an email to:
[email protected]
Quiz #2 (Results) 3
Q1) WRJ has a debt ratio of .4, current liabilities of
$18,000, and total assets of $120,000. What is the
level of WRJ's total liabilities?
A) $22,000 B) $48,000 C) $58,000 D) $63,934
$120,000 x .4
Q2) Bill's Bike Shop has a return on assets of 12%. Its

assets = $100 while its owner's equity = $40 and its
debt equals $60. What is Bill's return on equity?
A) 18% B) 20% C) 30% D) 12%
$100 x .12 / $40
Correct Answer (Quiz 2)

Please refer to the following balance sheet Apollo Corp.
reported for Q3 and Q4:
Cash $28,000 Accounts payable $5,000
Accounts receivable 15,000 Notes Payable 12,000
Inventory 45,000 Accruals 17,000
Net Fixed Assets 122,000 Long-Terms Debt 45,000
Common Stock 10,000

Retained Earnings 121,000
Total assets $210,000 Total Liabilities & $210,000
Equity

Q3) Apollo Corp.'s debt ratio is .
A) 32.17% B) 37.62% C) 39.45% D) 42.95%
(5,000+12,000+17,000+45,000) / 210,000=0.3762
Q4) Apollo has sales of $600,000 and net income of

$50,000. Apollo's return on equity is .
A) 5.00% B) 50.00% C) 38.17% D) 41.13%
50,000 / (10,000+121,000) =0.3817

Q5) The present value of $1,000 to be received in 5
years is if the discount rate is 12.78%.
A) $368 B) $494 C) $548 D) $687
(RATE=12.78, CPT PV=-548.07, PMT=0, FV=1,000, PERIOD=5)
Q6) At what rate must $287.50 be compounded

annually for it to grow to $650.01 in 14 years?
A) 6 % B) 5 % C) 7 % D) 8 %
(CPT RATE=6.00, PV=-287.50, PMT=0, FV=650.01, PERIOD=14)

Q7) What is the present value of $11,463 to be received 7 years
from today? Assume a discount rate of 3.5% compounded
annually and round to the nearest $1.
A) $5,790 B) $6,508 C) $7,210 D) $9,010
(RATE=3.5, CPT PV=-9,009.81, PMT=0, FV=11,463, PERIOD=7)
Q8) Your grandparents deposit $2,000 each year on your birthday,

starting the day you are born, in an account that pays 7%
interest compounded annually. How much will you have in the
account on your 21st birthday, just after your grandparents
make their deposit?
A) $101,802 B) $98,011 C) $86,058 D) $79,640
(RATE=7, PV=0, PMT=-2,000, CPT FV=96,011.48, PERIOD=21, Beginning mode)
$96,011.48 + $2,000 = $98,011.48

Q9) What is the present value of an annuity of $4,000
received at the beginning of each year for the next eight
years? The first payment will be received today, and the
discount rate is 9% (round to nearest $1).
A) $36,288 B) $35,712 C) $25,699 D) $24,132
(RATE=9, CPT PV=24,131.81, PMT=-4,000, FV=0, PERIOD=8)
Q10) Today is your 21st birthday and your bank account

balance is $25,000. Your account is earning 6.5%
interest compounded quarterly. How much will be in the
account on your 50th birthday?
A) $159,795 B) $162,183 C) $163,832 D) $164,631
(RATE=6.5, PV=-25,000, PMT=0, CPT FV=162,182.80, PERIOD=29X4=116, Quarterly)

Q11) How managers choose to finance the business does not
affect the rate of return to shareholders because the rate
of return is based on how the company uses the assets it
has, not whether or not they paid for the assets with debt
or equity.
False (ROE changes when a debt ratio changes)
Correct Answer (Quiz 2) 10

Q12) A car manufacturer offers either $2,000 cash back or zero percent
financing for 5 years. A rational consumer will always take the cash
back because money received today is worth more than money
received in the future. False (It depends on market interest rates)
Assume that you have $8,000 in an account and a new car costs $10,000.
a) Buy a new car with your saving plus $2,000 cash back
Your account balance: $0 in year 0, $0 in year 5
b) Take out a $10,000 loan to buy a new car and keep $8,000 in an account.
If the account yields 10% interest, the balance in year 5 will be $12,844.
→After the repayment of $10,000, you still have $2,844 in your account.
If the account yields 3% interest, the balance in year 5 will be $9,274.
→You’ll have a shortage of $726 to repay the $10,000 loan.

Q13) The present value of an annuity increases as the
discount rate increases.
False
Q14) For a given stated interest rate, an investor would
receive a greater future value with daily compounding as
opposed to monthly compounding.
True
Q15) The present value of a $100 perpetuity discounted at 5%
is $5,000. False ($20,000 = $100 / 0.05)

Q16) Discuss five limitations to financial ratio analysis.
*You should mention five limitations out of six discussed

in the textbook:
1. Industry identification is difficult.
2. Industry averages are only approximations.
3. Accounting practices differ widely among firms.
4. Financial ratios can be too high or too low.
5. The industry average may not be ideal.
6. Seasonality in firm operations causes ratios to vary
with seasons.
Model Answer (Quiz 2) 13

Q17) Suppose you were considering depositing your savings in one of the
three banks, all of which pay 5 percent interest; bank A compounds
annually, bank B compounds semiannually, and bank C compounds
daily. Which bank would you choose? Why?
Bank C, which compounds daily, pays the highest

interest. This occurs because, while all banks pay the
same interest, 5 percent, bank C compounds the 5
percent daily. Daily compounding allows interest to be
earned more frequently than semiannual or annual
compounding.
Model Answer (Quiz 2) 14

Foundations of Finance
Tenth Edition, Global Edition
Chapter 6
The Meaning and Measurement
of Risk and Return
Copyright © 2020 Pearson Education Ltd. All Rights Reserved

Learning Objectives
6.1 Define and measure the expected rate of return of an
individual investment.
6.2 Define and measure the riskiness of an individual
investment.
6.3 Compare the historical relationship between risk and
rates of return in the capital markets.
6.4 Explain how diversifying investments affects the riskiness
and expected rate of return of a portfolio or combination
of assets.
6.5 Explain the relationship between an investor’s required
rate of return on an investment and the riskiness of the
investment.
FLASHBACK
Principle 3: Risk Requires a Reward

• Investors will not take on additional risk unless they
expect to be compensated with additional reward or
return.
• Investors expect to be compensated for “delaying
consumption’’ and “taking on risk.’’
– Thus, investors expect a return when they deposit their
savings in a bank (e.g., delayed consumption), and
they expect to earn a relatively higher rate of return on
stocks compared to a bank savings account (e.g.,
taking on risk).

FLASHBACK
Figure 1.1 The Risk-Return Trade-off

Expected Return Defined and
Measured

Holding-Period Return (1 of 2)
• Historical or holding-period or realized rate of return
– Holding-period return = payoff during the "holding"
period. Holding period could be any unit of time such as
one day, a few weeks, or a few years.
Holding - period dollar gain, DG

= priceend of period + cash distribution ( dividend ) - price begining of period ( 6 -1)

Holding-Period Return (2 of 2)
• You bought one share of Google for $837.17 on April 17
and sold it one week later for $862.76. Assuming no
dividends were paid, your dollar gain was:
862.76 – 837.17 = $25.59

Holding-Period Rate of Return
Rate of Holding - Period Rate of Return
dollar gain Pend of period + Dividend − Pbeginning of period
return, r = =
Pbeginning of period Pbeginning of period
Google = 25.59 / 837.17 = 0.0306 = 3.06%

Expected Return (1 of 2)
• Expected cash flows and expected rate of return
– The expected benefits or returns an investment
generates come in the form of cash flows
– Cash flows are used to measure returns (not
accounting profits).

Expected Return (2 of 2)
• The expected cash flow is the weighted average of the
possible cash flow outcomes such that the weights are
the probabilities of the occurrence of the various states of
the economy.
Expected Cash flow ( X ) =  Pbi × CFi
Where Pbi = probabilities of outcome i

CFi = cash flows in outcome i

Table 6.1 Measuring the Expected
Return of an Investment
 Cash Flow 
 Investment Cost 
 

Expected Cash Flow
Expected Cash flow =  Pbi × CF1
= 0.2 ×1000 + 0.3×1200 + 0.5×1400

= $1,260 on $10,000 investment

Table 6.1 Measuring the Expected
Return of an Investment
 Cash Flow 
 Investment Cost 
 

Expected Rate of Return (2 of 2)
Expected Return (%) =  Pbi × ri
where Pi = probabilities of outcome i

ki = expected % return in outcome I
= 0.2 (10% ) + 0.3 (12% ) + 0.5 (14% )
= 12.6%

Assume that an investment is forecasted to
produce the following returns: a 10% probability
of a $1,400 return; a 50% probability of a $6,600
return; and a 40% probability of a $1,500 return.
What is the expected amount of return this
investment will produce?
A) $4,040
B) $7,640
C) $12140
D) $1,540
Question 1 29
Assume that an investment is forecasted to
produce the following returns: a 30% probability
of a 12% return; a 50% probability of a 16%
return; and a 20% probability of a 19% return.
What is the expected percentage return this
investment will produce?
A) 33.3%
B) 16.1%
C) 9.5%
D) 15.4%
Question 2 30
Risk Defined and Measured

Risk
1. What is risk?
2. How do we measure risk?
3. Will diversification reduce the risk of portfolio?

Risk Defined
• Risk refers to potential variability (volatility) in future
cash flows.
• The wider the range of possible future events that can
occur, the greater the risk.
• Thus, the returns on common stock are more risky than
returns from investing in a savings account in a bank.

Risk Measured
Consider two investment options:
1. Invest in Treasury bond that offers a 2 percent annual
return.
2. Invest in stock of a local publishing company with an
expected return of 14 percent based on the payoffs
(given on next slide).

Probability of Payoffs
• Stock
Chance of Occurrence Rate of Return on Investment
1 chance in 10 (10% chance) −10%
2 chances in 10 (20% chance) 5%
1 chance in 10 (10% chance) 30%
• Treasury Bond
– 100% chance of 2%

Expected Rate of Return
• Treasury bond = 1×2% = 2%
• Stock
= 0.1×(−10) + 0.2×5% + 0.4×15% + 0.2×25% +
0.1×30% = 14%

Figure 6.1 The Probability
Distribution of the Returns on Two
Investments

Treasury Bond versus Stock
• We observe from Figure 6.1 that the stock of the
publishing company is more risky, but it also offers the
potential of a higher payoff (return).

Standard Deviation (S.D.) (1 of 2)
• Standard deviation (S.D.) is one way to measure risk. It
measures the volatility or riskiness of portfolio returns.
• S.D. = square root of the weighted average squared
deviation of each possible return from the expected return.

Probability of Payoffs
• Stock
Chance of Occurrence Rate of Return on Investment
1 chance in 10 (10% chance) −10%
1 chance in 10 (10% chance) 30%
• Expected rate of return

= 0.1×(−10) + 0.2×5% + 0.4×15% + 0.2×25% +
0.1×30% = 14%

Standard Deviation (S.D.) (2 of 2)
1
( −10% − 14% )2 ( 0.10 ) + ( 5% − 14% )2 ( 0.20 )  2
 
σ =  + (15% − 14% ) ( 0.40 ) + ( 25% − 14% ) ( 0.20 ) 
2 2
 
 + ( 30% − 14% ) ( 0.10 )
2

 
= 124% = 11.14%

Table 6.2 Measuring the Variance and Standard
Deviation of the Publishing Company Investment
State of the Rate of Chance or
World Return Probability Step 1 Step 2 Step 3
( )
2
A B C D=B×C E = B−r F=E×C
1 −10% 0.10 −1% 576% 57.6%

3 5% 0.20 1% 81% 16.2%
4 15% 0.40 6% 1% 0.40%
5 25% 0.20 5% 121% 24.2%
6 30% 0.10 3% 256% 25.6%
Step 1: Expected Return (r) = → 14%

Step 4: Variance = → 124%
Step 5: Standard Deviation = → 11.14%
Comments on Standard Deviation
• There is a 68% probability (two-thirds of the time) that
the actual returns will fall between 2.86% (=14% - 11.14%)
and 25.14% (=14% + 11.14%). So actual returns are far
from certain!
• Risk is relative; to judge whether 11.14% is high or low
risk, we need to compare the standard deviation of this
stock to the standard deviation of other investment
alternatives.
• To get the full picture, we need to consider not only the
standard deviation but also the expected return.
• The choice of a particular investment depends on the
investor’s attitude toward risk.
Normal Distribution and SD (σ）
The normal distribution curve is symmetric about its mean (μ).

Normal Distribution and SD (σ）

Rates of Return: The Investor's
Experience

Figure 6.2 Historical Rates of Return
Real
Nominal Standard Average Risk
Securities
Average Annual Deviation of Annual Premium
Returns Returns Returns a b
Small company stocks 16.6% 31.9% 13.7% 13.2%

Large company stocks 12.0% 19.9% 9.1% 8.6%
Intermediate-term
5.3% 5.6% 2.4% 1.9%
government bonds
Corporate bonds 6.3% 8.4% 3.4% 2.9%
U.S. Treasury bills 3.4% 3.1% 0.5% 0.0%
Inflation 2.9% 3.0% Blank Blank
a The real return equals the nominal returns less the inflation rate of 2.9 percent.
b The risk premium equals the nominal security return less the average risk-free rate
(Treasury bills) of 3.4 percent.
Source: Data from Summary Statistics of Annual Total Returns: 1926 to 2016 Yearbook,
Ibbotson Associates Inc.
Rates of Return: The Investor’s
Experience (1926–2016)
Figure 6.2 shows:
A. The direct relationship between risk and return.
B. Only common stocks provide a reasonable hedge against
inflation.
• The study also observed that between 1926 and 2016,
large stocks had negative returns in 22 of 91 years, while
Treasury bills generated negative returns in only one year.

Stock W has the following returns for various states of
the economy:
State of the Economy Probability Stock W's Return
Recession 10% -30%
Below Average 20% -2%
Average 40% 10%
Above Average 20% 18%
Boom 10% 40%
Stock W's standard deviation of returns is .

A) 10% B) 14% C) 17% D) 20%
Question 3 49
Stock W has an expected return of 12% with a standard
deviation of 8%. If returns are normally distributed, then
approximately two-thirds of the time the return on stock
W will be .
A) between 12% and 20%.

B) between 8% and 12%.
C) between -4% and 28%.
D) between 4% and 20%.
Question 4 50
Siam Cement Group (SCG) is planning to invest in a
security that has several possible rates of returns.
Given the following probability distribution of returns,
what is the expected rate of return on the investment?
Also, compute the standard deviation of the returns.
What do the resulting numbers represent?
Probability Return
0.09 -9%
0.19 6%
0.29 10%
0.43 26%
Group Discussion 1 51
Risk and Diversification

Portfolio
“Don’t Put All your Eggs in One Basket”

Portfolio
• Portfolio refers to combining several assets.
• Examples of portfolio:
– Investing in multiple financial assets (stocks – $6000,
bonds – $3000, T-bills – $1000)
– Investing in multiple items from a single market
(example: investing in 30 different stocks)

• Total risk of portfolio is due to two types of risk:
– Systematic (or market risk) is risk that affects all firms
(e.g., tax rate changes, war)
– Unsystematic (or company-unique risk) is risk that
affects only a specific firm (e.g., labor strikes, CEO
change)
• Only unsystematic risk can be reduced or eliminated
through effective diversification.

Figure 6.3 Variability of Returns
Compared with Size of Portfolio

Correlation and Risk Reduction (1 of 2)
• The main motive for holding multiple assets or creating a

portfolio of stocks (called diversification) is to reduce the
overall risk exposure. The degree of reduction depends on
the correlation among the assets.
– If two stocks are perfectly positively correlated,
diversification has no effect on risk.
– If two stocks are perfectly negatively correlated, the
portfolio is perfectly diversified.

Correlation and Risk Reduction (2 of 2)
• Thus, while building a portfolio, we should pick
securities/assets that have negative or low-positive
correlation to realize diversification benefits.

How can investors reduce the risk associated with
an investment portfolio without having to accept
a lower expected return?
A) Wait until the stock market rises.
B) Increase the amount of money invested in
the portfolio.
C) Purchase a variety of securities; i.e.,
diversify.
D) Purchase stocks that have exceptionally
high standard deviations.
Question 5 59
You are considering investing in Ford Motor Company.
Which of the following are examples of diversifiable risk?
1. Risk resulting from possibility of a stock market crash.

2. Risk resulting from uncertainty regarding a possible
strike against Ford.
3. Risk resulting from an expensive recall of a Ford product.
4. Risk resulting from interest rates decreasing.
A) 1 only B) 1 and 4 C) 1, 2, 3, and 4 D) 2 and 3
Question 6 60
Market Risk or Systematic Risk
• Measuring Market Risk:
– eBay vs. S&P 500 Index
• Table 6.3 and Figure 6.4 display the monthly returns for
eBay and the S&P 500 Index.

Table 6.3 Monthly Holding-Period Returns, eBay
versus the S&P 500 Index, February 2017
through January 2018

Figure 6.4 Monthly Holding-Period Returns, eBay
versus the S&P 500 Index, February 2017
through January 2018
Source: Data from Yahoo Finance

From Figure 6.4 and Table 6.3
• Average monthly return: eBay = 2.15%
• S&P 500 Index = 1.86%
• Risk was higher for eBay with standard deviation of 4.75%
versus 1.64% for S&P 500.
• There is a moderate positive relationship in the movement
of returns between eBay and S&P 500 (in 9 of the 12
months).

Interpreting Beta
• Beta is the risk that remains for a company even after we
have diversified our portfolio.
– A stock with a Beta of 0 has no systematic risk.
– A stock with a Beta of 1 has systematic risk equal to
the “typical” stock in the marketplace.
– A stock with a Beta exceeding 1 has systematic risk
greater than the “typical” stock.
• Most stocks have betas between 0.60 and 1.60. Note, the
value of beta is highly dependent on the methodology and
data used.

Interpreting Beta
Company Name Beta
Amazon 1.49
Apple 1.06
Coca-Cola 0.25
PepsiCo 0.55
ExxonMobil 0.81
General Electric 0.61
IBM 0.97
Lowe’s 1.36
Merck 0.62
Nike 0.81
Wal-Mart 0.70
(From page 233 of the textbook)

Demonstrated
• The market rewards diversification.
• Through effective diversification, we can lower risk without
sacrificing expected returns, and we can increase
expected returns without having to assume more risk

Asset Allocation
• Asset allocation refers to diversifying among different kinds
of asset types (such as treasury bills, corporate bonds,
common stocks).
• Asset allocation decision has to be made today—the
payoff in the future will depend on the mix chosen before,
which cannot be changed. Hence asset allocation decision
is considered the “most important decision” while
managing an investment portfolio.

Figure 6.8 The Effect of Diversifying and
Investing for Longer Periods of Time on
Risk and Returns.
Source: Data from Summary Statistics of Annual Total Returns: 1926 to 2011 Yearbook,
Ibbotson Associates, Inc.
Asset Allocation Matters!
• We observe the following from Figure 6.8.
– Direct relationship between risk and return: As we
move from an all-stock portfolio to a mix of stocks and
bonds to an all-bond portfolio, both risk and return
decline.
– Holding period matters: As we increase the holding
period, risk declines.

Asset Allocation Summary
• There has never been a time when investors lost money if
they held an all-stock portfolio—the most risky portfolio—for
10 years.
– The market rewards the patient investor.

The Investor's Required Rate of
Return

The Investor’s Required Rate of
Return
• Investor’s required rate of return is the minimum rate of
return necessary to attract an investor to purchase or hold
a security.
• This definition considers the opportunity cost of funds, i.e.,
the forgone return on the next best investment.

The Investor’s Required Rate of
Return Equation 6.11
Investor’s required rate of return = risk-free rate of return +
risk premium

Risk-Free Rate
• This is the required rate of return or discount rate for risk-
free investments.
• Risk-free rate is typically measured by the U.S. Treasury
bill rate (in the U.S.)
• The Japanese government bond (JGB) rate in Japan
• The four countries that have gone bankrupt but lived:

Iceland (2008), Argentina (2001), Russia (1998)
and Mexico (1982).

Risk Premium
• The risk premium is the additional return we must expect
to receive for assuming risk.
• As the level of risk increases, we will demand additional
expected returns.

Capital Asset Pricing Model (CAPM)
(1 of 2)
• CAPM equation equates the expected rate of return on a
stock to the risk-free rate plus a risk premium for the
systematic risk.
• CAPM provides for an intuitive approach for thinking about
the return that an investor should require on an
investment, given the asset’s systematic or market risk.

CAPM Equation 6.13
• CAPM suggests that beta is a factor in determining the
required returns.

Capital Asset Pricing Model (CAPM)
(2 of 2)
Market rate of return = 10%
Risk-free rate = 3%
Required return = 3% + beta x (10% - 3%)
If beta = 0 Required return = 3%


CAPM Example
• Market rate of return = 10%
• Risk-free rate = 3%
• Required return = 3% + beta×(10% − 3%)
Beta Required Return

0 3%
1 10%
2 17%

Wildings, Inc. common stock has a beta of 1.2.
If the expected risk free return is 4% and the
expected market risk premium is 9%, what is
the expected return on Wildings' stock?
A) 10.0% B) 12.0% C) 13.8% D) 14.8%
Question 7 81
If the beta for stock A equals zero, then
A) stock A's required return is equal to the required
return on the market portfolio.
B) stock A's required return is equal to the risk-free
rate of return.
C) stock A has a guaranteed return.
D) stock A's required return is greater than the
required return on the market portfolio.
Question 8 82
Surf and Spray Inc. has a beta equal to 1.8
and a required return of 15% based on the
CAPM. If the market risk premium is 7.5%,
the risk-free rate is .
A) 4.1% B) 3.4% C) 2.0% D) 1.5%
Group Discussion 2 83
Chapter 7
“The Valuation and
Characteristics of Bonds”
(pp. 254-285)
Finance B (Nov. 25)

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Finance A

November 11, 2021 (Week 7)

Q2) Bill's Bike Shop has a return on assets of 12%. Its

Correct Answer (Quiz 2)

Accounts receivable 15,000 Notes Payable 12,000

Inventory 45,000 Accruals 17,000

Net Fixed Assets 122,000 Long-Terms Debt 45,000

Common Stock 10,000

Correct Answer (Quiz 2)

Q4) Apollo has sales of $600,000 and net income of

Correct Answer (Quiz 2)

Q6) At what rate must $287.50 be compounded

Correct Answer (Quiz 2)

Q8) Your grandparents deposit $2,000 each year on your birthday,

Correct Answer (Quiz 2)

Q10) Today is your 21st birthday and your bank account

Correct Answer (Quiz 2)

False (ROE changes when a debt ratio changes)

Correct Answer (Quiz 2) 10

Correct Answer (Quiz 2) 11

Correct Answer (Quiz 2) 12

*You should mention five limitations out of six discussed

Model Answer (Quiz 2) 13

Bank C, which compounds daily, pays the highest

Model Answer (Quiz 2) 14

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Principle 3: Risk Requires a Reward

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Figure 1.1 The Risk-Return Trade-off

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Holding - period dollar gain, DG

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Google = 25.59 / 837.17 = 0.0306 = 3.06%

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Expected Cash flow ( X ) =  Pbi × CFi

Where Pbi = probabilities of outcome i

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= 0.2 ×1000 + 0.3×1200 + 0.5×1400

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where Pi = probabilities of outcome i

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• Treasury bond = 1×2% = 2%

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• Expected rate of return

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