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Fin 415 Risk Management Set I

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Risk Management Set I
6-1. (Expected rate of return and risk) Carter Inc. is evaluating a security. One-year Treasury bills are currently paying 9.1 percent. Calculate the investment’s expected return and its standard deviation. Should Carter invest in this security?

PROBABILITY RETURN
.15 6%
.30 9%
.40 10%
.15 15%

Expected Rate of Return: (.15x.06) + (.30x09) + (.40x.1) + (.15x.15) .009 + .027 + .04 + .0225= .0985 or 9.85%

Standard Deviation: √((.15)(.06x.0985)^2 + (.30)(.09x.0985)^2 + (.40)(.10x.0985)^2 + (.15)(.15x.0985)) = √.0023= .0479583 or 4.8%

I would suggest for Carter to invest in the security. The expected rate of return is higher than the One-year Treasury is. Of course Carter would have to be willing to take the risk of the security. The treasury is set and more reliable than the security. I would suggest investing in the security.

10-15. (Risk-adjusted discount rates and risk classes) The G. Wolfe Corporation is examining two capital-budgeting projects with 5-year lives. The first, project A, is a replacement project; the second, project B, is a project unrelated to current operations. The G. Wolfe Corporation uses the risk-adjusted discount rate method and groups projects according to purpose, and then it uses a required rate of return or discount rate that has been preassigned to that purpose or risk class. The expected cash flows for these projects are given here:

PROJECT A PROJECT B
Initial investment -$250,000 -$400,000
Cash inflows:
Year 1 $130,000 $135,000
Year 2 40,000 135,000
Year 3 50,000 135,000
Year 4 90,000 135,000
Year 5 130,000 135,000

The purpose/risk classes and preassigned required rates of return are as follows:
PURPOSE REQUIRED RATE OF RETURN
Replacement decision 12%
Modification or expansion of existing product line 15…...

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