LG2LG1LG1LG1CHAPTER 5 Risk and Return 249PROBLEMS
5–1 Rate of return Douglas Keel, a financial analyst for Orange Industries, wishes to
estimate the rate of return for two similar-risk investments, X and Y. Keel’s
research indicates that the immediate past returns will serve as reasonable esti-
mates of future returns. A year earlier, investment X had a market value of
$20,000, investment Y of $55,000. During the year, investment X generated cash
flow of $1,500 and investment Y generated cash flow of $6,800. The current mar-
ket values of investments X and Y are $21,000 and $55,000, respectively.
a. Calculate the expected rate of return on investments X and Y using the most
recent year’s data.
b. Assuming that the two investments are equally risky, which one should Keel
recommend? Why?5–2 Return calculations For each of the investments shown in the following table,
calculate the rate of return earned over the unspecified time period.5–3 Risk preferences Sharon Smith, the financial manager for Barnett Corporation,
wishes to evaluate three prospective investments: X, Y, and Z. Currently, the
firm earns 12% on its investments, which have a risk index of 6%. The expected
return and expected risk of the investments are as follows:a. If Sharon Smith were risk-indifferent,which investments would she select?
Explain why.
b. If she were risk-averse,which investments would she select? Why?
c. If she were risk-seeking,which investments would she select? Why?
d. Given the traditional risk preference behavior exhibited by financial man-
agers, which investment would be preferred? Why?5–4 Risk analysis Solar Designs is considering an investment in an expanded prod-
uct line. Two possible types of expansion are being considered. After investigatingExpected Expected
Investment return risk indexX 14% 7%
Y12 8
Z10 9Cash flow Beginning-of- End-of-
Investment during period period value period valueA $ 100 $ 800 $ 1,100
B 15,000 120,000 118,000
C 7,000 45,000 48,000
D 80 600 500
E 1,500 12,500 12,400