Principles of Managerial Finance

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CHAPTER 5 Risk and Return 259

Draw the new SML on the axes in part a,and calculate and show the new

required return for asset A.

d. Assume that as a result of recent events, investors have become more risk-

averse, causing the market return to rise by 1%, to 13%. Ignoring the shift in

part c,draw the new SML on the same set of axes that you used before, and

calculate and show the new required return for asset A.

e. From the previous changes, what conclusions can be drawn about the impact

of (1) decreased inflationary expectations and (2) increased risk aversion on

the required returns of risky assets?

5–28 Integrative—Risk, return, and CAPM Wolff Enterprises must consider several

investment projects, A through E, using the capital asset pricing model (CAPM)

and its graphical representation, the security market line (SML). Relevant infor-

mation is presented in the following table.

a. Calculate the required rate of return and risk premium for each project, given

its level of nondiversifiable risk.

b. Use your findings in part ato draw the security market line (required return

relative to nondiversifiable risk).

c. Discuss the relative nondiversifiable risk of projects A through E.

d. Assume that recent economic events have caused investors to become less

risk-averse, causing the market return to decline by 2%, to 12%. Calculate

the new required returns for assets A through E, and draw the new security

market line on the same set of axes that you used in part b.

e. Compare your findings in parts aand bwith those in part d.What conclu-

sion can you draw about the impact of a decline in investor risk aversion on

the required returns of risky assets?

CHAPTER 5 CASE Analyzing Risk and Return on Chargers Products’ Investments

J

unior Sayou, a financial analyst for Chargers Products, a manufacturer of sta-

dium benches, must evaluate the risk and return of two assets, X and Y. The

firm is considering adding these assets to its diversified asset portfolio. To assess

the return and risk of each asset, Junior gathered data on the annual cash flow

and beginning- and end-of-year values of each asset over the immediately pre-

ceding 10 years, 1994–2003. These data are summarized in the accompanying

table. Junior’s investigation suggests that both assets, on average, will tend to

Item Rate of return Beta, b

Risk-free asset 9% 0

Market portfolio 14 1.00

Project A — 1.50

Project B — .75

Project C — 2.00

Project D — 0

Project E — .50