Question

ou plan to invest in the Kish Hedge Fund, which has total capital of $500 million invested in five stocks:

Stock	Investment	Stock's Beta Coefficient
A	$160 million	0.6
B	120 million	1.4
C	80 million	2.3
D	80 million	1.0
E	60 million	1.7

Kish's beta coefficient can be found as a weighted average of its stocks' betas. The risk-free rate is 3%, and you believe the following probability distribution for future market returns is realistic:

Probability	Market Return
0.1	-25	%
0.2	0
0.4	11
0.2	31
0.1	52

1. What is the equation for the Security Market Line (SML)? (Hint: First determine the expected market return.)
   1. r_i = 3.0% + (10.3%)b_i
   2. r_i = 4.3% + (9.5%)b_i
   3. r_i = 3.0% + (10.4%)b_i
   4. r_i = 5.2% + (10.3%)b_i
   5. r_i = 5.2% + (10.4%)b_i

   -Select-IIIIIIIVVItem 1

2. Calculate Kish's required rate of return. Do not round intermediate calculations. Round your answer to two decimal places.

     %

3. Suppose Rick Kish, the president, receives a proposal from a company seeking new capital. The amount needed to take a position in the stock is $50 million, it has an expected return of 15%, and its estimated beta is 1.4. Should Kish invest in the new company?

   The new stock -Select-should notshouldItem 3 be purchased.

   At what expected rate of return should Kish be indifferent to purchasing the stock? Round your answer to two decimal places.

     %

Answer 1

a) Market Return, rm = Sum prob x Market returns = 0.1 x -25% + 0.2 x 0 + 0.4 x 11% + 0.2 x 31% + 0.1 x 52% = 13.3%

Using SML, ri = rf + bi x (rm - rf) = 3% + bi x (13.3% - 3%) = 3% + 10.3% x bi

Hence, I is true.

b) Kish's beta = (160 x 0.6 + 120 x 1.4 + 80 x 2.3 + 80 x 1 + 60 x 1.7) / 500 = 1.26

Required Return = 3% + 1.26 x 10.3% = 15.98%

c) Required Return = 3% + 1.4 x 10.3% = 17.42%

As the expected return (15%) is lower than required return (17.42%). The stock should not be purchased.

Indifference rate = 17.42%