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If the reason that people invest is to have more money to spend later in life, then the real return
measures the increase in spending power over time. It is not how much money you have that
counts, its how much you can buy with that money.
Q6-4. Explain why dollar returns and percentage returns can sometimes send conflicting signals when
you are comparing two different investments.
A6-4.
If the two investments require the same amount of money up front, this will not usually be a
problem. However, if one investment is much larger than another, then the larger investment can
generate a higher dollar return while the smaller one generates a higher percentage return. For
example, suppose one person invests $100 and earns a total dollar return of $10, while another
1
person invests $50 and earns a total dollar return of $6. Clearly the dollar return is larger on the
first investment, but the percentage return is higher on the second.
Q6-6. Look at Table 6.1. Compare the best and worst years for Tbills in terms of their nominal returns,
and then compare the best and worst years in terms of real returns. Comment on what you find.
A6-6.
The spread between the best and worst years is 14.7% in nominal terms and 34.8% in real terms.
In part this is because the nominal return on Treasury bills has a floor at zero percent, but the
real return can be, and often has been negative. This occurs when the inflation rate is higher than
the nominal interest rate.
You purchase 1,000 shares of Spears Grinders Inc. stock for $45 per share. A year later, the stock
pays a dividend of $1.25 per share and it sells for $49.
a. Calculate your total dollar return.
b. Calculate your total percentage return.
c. Do the answers to parts (a) and (b) depend on whether you sell the stock after one year or
continue to hold it?
A6-1.
P6-3.
D. S. Trucking Company stock pays a $1.50 dividend every year. A year ago the stock sold for
$25 per share, and its total return during the past year was $20%. What does the stock sell for
today?
A6-3.
P6-5.
David Rawlings pays $1,000 to buy a five-year Treasury bond that pays a six percent coupon rate
(for simplicity, assume annual coupon payments). One year later, the markets required return on
this bond has increased from six percent to seven percent. What is Rawlings total return (in dollar
and percentage terms) on the bond?
A6-5.
After one year, the bond price will fall to $966.13. The total dollar return is ($966.13 + $60 $1,000) = $26.13 and the percentage return is 2.613%. To solve for the $966.13 price of the
bond, use the following calculator inputs:
N = 4 (Note that 4 is used, since one year has passed and there are four years remaining in the life
of the bond)
PMT = 60 (6% $1,000)
FV = $1,000
I = 7%
Solve for PV (bond price) = -$966.13
P6-8.
Refer to Figure 6.2. At the end of each line we show the nominal value in 2003 of a $1
investment stocks, bonds, and bills. Calculate the ratio of the 2003 value of $1 invested in stocks
divided by the 2003 value of $1 invested in bonds. Now recalculate this ratio using the real values
in Figure 6.3. What do you find?
A6-8.
In nominal terms, this ratio is 15,579/148 = 105.3, and in real terms, 719/6.8 = 105.7, ratios
which are about the same. The relative performance of stocks vs. bonds (or bills for that matter)
does not depend on whether you measure dollars in nominal or real terms. When we switch from
nominal to real values, we are taking away the effect of inflation on both types of investments.
Because we are simultaneously making the same adjustment to stocks and bonds, their relative
performance does not change.
P6-13. If an investment promises a nominal return of six percent and the inflation rate is one percent,
what is the real return?
3
Stocks
Bonds
Premium
1950
10.2%
4.1%
?
1975
11.4%
2.4%
?
2000
16.2%
10.6%
?
A6-15. The risk premiums in each decade are 6.2%, 6.1%, 9.0%, and 5.6%. The main lesson is that the
observed equity risk premium is not constant through time.
P6-20. Use the data below to calculate the standard deviation of nominal and real Treasury bill returns
from 1972-1982. Do you think that when they purchased T-bills investors expected to earn
negative real returns as often as they did during this period? If not, what happened that took
investors by surprise?
Year
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
A6-20. The standard deviations are 3.3% in nominal terms and 3.2% in real terms. The negative real
return periods are times when actual inflation exceeded expected inflation. Investors had not
anticipated higher inflation and failed to require sufficient compensation for inflation during those
times. Note, though, that the mean of the 11-year period is 0.08, or very close to 0. In other
words, on average, those who invest in T-bills just break even with inflation.
P6-23. The table below shows annual returns on the pharmaceutical leader Merck and chip maker
Advanced Micro Devices. The last column of the table shows the annual return that a portfolio
invested 50% in Merck and 50% in AMD would have earned each year. The portfolios return is
simply a weighted average of the returns of Merck and AMD. An example portfolio return
calculation for 1994 is given at the top of the table.
Year
1994
1995
1996
1997
1998
AMD
40.1%
-33.7%
56.1%
-31.1%
63.4%
Merck
50-50 Portfolio
14.9% 27.5% (0.5 x 40.1% + 0.5 x 14.9%)
76.4%
24.0%
35.5%
41.2%
4
1999
2000
2001
2002
2003
Std.
Dev.
-0.2% -7.4%
-4.5% 41.7%
14.8% -35.9%
-59.3% -1.1%
130.7% -11.2%
a. Plot a graph similar to Figure 6.7 showing the returns on Merck and AMD each year.
b. Fill in the blanks by calculating the 50-50 portfolios return each year from 1995-2003 and
then plot this on the graph you created for part (a). How does the portfolio return compare to
the returns of the individual stocks in the portfolio?
c. Calculate the standard deviation of Merck, AMD, and the portfolio and comment on what you
find.
A6-23 a. The graph appears below. Notice that in many years, Merck has a good year when AMD
stock doesnt do very well, and vice versa.
b. The annual returns on the portfolio, starting in 1994 and going to 2003 are: 27.5%, 21.4%,
40.0%, 2.2%, 52.3%, -3.8%, 18.6%, -10.55%, -30.2%, and 59.75%.
c. The standard deviation of Merck, AMD, and the portfolio are 56.4%, 32.7%, and 28.6%
respectively. The portfolio is less volatile than either stock in the portfolio.
Chapter 7
a. At the end of 1973, the yield on Treasury bonds was 6.6% and the yield on T-bills was 7.2%.
Using these figures and the historical data above from 1964-1973, construct two estimates of
the expected return on equities as of December 1973.
b. At the end of 1983, the yield on Treasury bonds was 6.6% and the yield on T-bills was 7.2%.
Using these figures and the historical data above from 1974-1983, construct two estimates of
the expected return on equities as of December 1983.
c. At the end of 1993, the yield on Treasury bonds was 6.6% and the yield on T-bills was 2.8%.
Using these figures and the historical data above from 1984-1993, construct two estimates of
the expected return on equities as of December 1993.
d. At the end of 2003, the yield on Treasury bonds was 5.0% and the yield on T-bills was 1.0%.
Using these figures and the historical data above from 1994-2003, construct two estimates of
the expected return on equities as of December 2003.
e. What lessons do you learn from this exercise? How much do your estimates of the expected
return on equities vary over time, and why do they vary?
A7-2. a. Using T bonds, expected return on stocks was 6.6% + 3.7% = 10.3%. Using T bills, it was
7.2% + 8.3% = 15.5%.
b. Using T bonds, expected return on stocks was 6.6% + .2% = 6.8%. Using T bills, it was 7.2%
+ 8.6% = 15.8%
c. Using T bonds, expected return on stocks was 6.6% + 7.5% = 14.1%. Using T bills, it was
2.8% + 5.4% = 8.2%.
d. Using T bonds, expected return on stocks was 5% + 4.8% = 9.8%. Using T bills, it was 1% +
2.1% = 3.1%.
e. This shows that the risk premium on stocks is very variable over time. Returns depend on
how stocks are performing and on interest rates. Ten years is probably not a long enough
period on which to compute a long-term market risk premium
P7-3.
Use the information below to estimate the expected return on the stock of W.M. Hung
Corporation.
Long-run average stock return = 10%
Long-run average T-bill return = 4%
Current T-bill return = 2%
A7-3. The long-run risk premium on the stock is 6%, so add the current T-bill rate, 2%, to get Hungs
expected return, 8%.
P7-4.
Calculate the expected return, variance, and standard deviation for the stocks in the table below.
P7-20. The expected return on the market portfolio equals 12%. The current risk-free rate is 6%. What
is the expected return on a stock with a beta of 0.66?
A7-20. R = Rf + B(Rm Rf)
= 6 + 0.66 (12-6)
= 9.96%
P7-21. The expected return on a particular stock is 14%. The stocks beta is 1.5. What is the risk-free
rate if the expected return on the market portfolio equals 10%.
A7-21. R = Rf + B(Rm Rf)
14 = Rf + 1.5 x (10 Rf)
14 = Rf + 15 1.5Rf
Rf = 2
P7-24. A particular stock sells for $30. The stocks beta is 1.25, the risk-free rate is 4%, and the expected
return on the market portfolio is 10%. If you forecast that the stock will be worth $33 next year
(assume no dividends), should you buy the stock or not?
A7-24. R = Rf + (Rm Rf) x Beta
= 4 + 1.25 (10 4) = 11.5%
Return on the stock: (33-30)/30 = 10%.
Dont buy the stock. You expect a return of 10%. The stock should return 11.5%, according to
CAPM.
Chapter 8
Answers to Concept Review Questions
1. Other things being equal, managers would prefer (1) an easily applied capital budgeting technique
that (2) considers cash flow, (3) recognizes the time value of money, (4) fully accounts for expected
risk and return, and (5) when applied, leads to higher stock prices.
4. Payback is popular because it is very easy to compute and to understand and because it gives
managers a rough measure of how soon they will receive intermediate cash flows from a project that
they could potentially invest in other projects. It would be used primarily in situations that feature
quick turnover of projects.
5. The major flaws of the payback and discounted payback methods are that payback method does not
take the time value of money into account and they both ignore cash flows beyond the payback
period.
8. IRR and NPV are related in that both use the time value of money and take risk into account. NPV
accounts for risk by using a risk-adjusted discount rate, while IRR uses a risk-adjusted hurdle rate
against which to compare the project and make the accept/reject decision.
10. You will recall that the scale problem indicates that we should use practical sense along with IRR
analysis: we should choose the investment that offers the best ABSOLUTE payoff to maximize
shareholder wealth, regardless of its percentage payoff. The timing problem has to do with
managers inability or unwillingness to look at the longer term and simply look for the next best fix
short term payoffs rather than visionary projects that involve R&D and the like. The firm can use
IRR with mutually exclusive projects by subtracting one set of cash flows from the other and finding
the IRR of the project that represents these differential cash flows. If the differential project has
9
conventional cash flows, then accept the project on top if the IRR exceeds the hurdle rate. If the
differential project has non-conventional cash flows, then accept the project on the top of the
subtraction if the hurdle rate exceeds the IRR.
11. NPV, IRR, and PI capital budgeting approaches are related because they adjust for the time value of
money and risk. Again, for a single project with conventional cash flows, all three methods will
provide the same accept/reject decision..
12. Choosing a project with the highest PI may not be the same as accepting a project with the highest
dollar NPV. To maximize shareholder wealth, a manager wants to add the most possible risk-adjusted
(positive NPV) dollars to the company. But while NPV is the best measure to use, it also demands a
certainty in measuring variables that few, if any, firms can provide. PI and IRR are both substitutes
for NPV, but they are only estimatesthey are not exact measures.
10
lower the firms average return and therefore lower the firms stock price. How do you
respond?
A8-8. a. A firm that consistently earns returns higher than its opportunity cost of capital is adding
value to the firm, and its stock price should increase.
b. For the project returning 18%, as long as it returns enough to compensate for the risk of the
project, it is adding value and shareholders will be happy about the decision to accept the
project.
Q8-9. What are the potential faults in using the IRR as a capital budgeting technique? Given these
faults, why is this technique so popular among corporate managers?
A8-9. The IRR suffers from several problems. The IRR is not well suited to ranking projects with very
different scales or projects with very different cash flow timing patterns. The IRR method can
also yield no solution or multiple solutions that are hard to interpret. Despite the flaws, the IRR
method enjoys widespread use because in most investment situations it generates reliable
accept/reject recommendations and it is easy to interpret intuitively.
Q8-10. Why is the NPV considered to be theoretically superior to all other capital budgeting techniques?
Reconcile this result with the prevalence of the use of IRR in practice. How would you respond to
your CFO if she instructed you to use the IRR technique to make capital budgeting decisions on
projects with cash flow streams that alternate between inflows and outflows?
A8-10. The NPV is the most appropriate capital budgeting method because it yields correct accept/reject
situations and correct project rankings. Nevertheless, it is somewhat less intuitive than the IRR.
In projects with cash flow stream that switch signs, the IRR method can yield multiple solutions.
In those cases, it is difficult for a firm to know whether to accept or reject a project based upon its
IRR.
Q8-11. Outline the differences between NPV, IRR, and PI. What are the advantages and disadvantages of
each technique? Do they agree with regard to simple accept or reject decisions?
A8-11. The NPV is calculated by discounting all of a projects cash flows to the present. The IRR is
calculated by finding the discount rate which equates the NPV to zero. The profitability index is
the ratio of the present value of a projects cash flows (excluding the initial cash outflow) divided
by the initial cash outflow. All three methods lead to the same accept/reject decision when
evaluating a single project, but IRR and PI have problems when ranking projects. NPV generally
overcomes these problems.
Q8-12. Under what circumstances will the NPV, IRR, and PI techniques provide different capital
budgeting decisions? What are the underlying causes of the differences often found in the ranking
of mutually exclusive projects using NPV and IRR?
A8-12. IRR, NPV, and PI can lead to different decisions when they are used to rank projects or to select
between mutually exclusive projects. IRR and PI methods are not well suited to evaluating
projects which vary in scale. The NPV method yields correct project rankings no matter what the
scale of the project.
The cash flows associated with three different projects are as follows:
Cash Flows
Alpha
($ in millions)
11
Beta
($ in millions)
Gamma
($ in millions)
Initial Outflow
Year 1
Year 2
Year 3
Year 4
Year 5
- 1.5
0.3
0.5
0.5
0.4
0.3
- 0.4
0.1
0.2
0.2
0.1
- 0.2
- 7.5
2.0
3.0
2.0
1.5
5.5
Calculate the net present value (NPV) for the following 20-year projects. Comment on the
acceptability of each. Assume that the firm has an opportunity cost of 14 percent.
a. Initial cash outlay is $15,000; cash inflows are $13,000 per year.
b. Initial cash outlay is $32,000; cash inflows are $4,000 per year.
c. Initial cash outlay is $50,000; cash inflows are $8,500 per year.
A8-4.
a. Project A has CFo = $-15,000, and 20 inflows of $13,000. At a 14% discount rate, its NPV is
$71,100.70. This is positive NPV and an acceptable project.
b. Project B has CFo = -$32,000 and 20 inflows of $4,000. At 14%, its NPV is -$5507.47. This
is negative NPV and is not acceptable.
c. Project C has CFo = -$50,000, and 20 inflows of $8,500. At a 14% discount rate, its NPV is
$6,296.61. This is positive NPV and an acceptable project
P8-7.
Scotty Manufacturing is considering the replacement of one of its machine tools. Three
alternative replacement toolsA, B, and Care under consideration. The cash flows associated
with each are shown in the following table. The firms cost of capital is 15 percent.
A
B
C
12
Initial cash
outflow (CFo)
Year (t)
1
2
3
4
5
6
7
8
$95,000
$20,000
20,000
20,000
20,000
20,000
20,000
20,000
20,000
$50,000
Cash Inflows (CFt)
$10,000
12,000
13,000
15,000
17,000
21,000
-
$150,000
$58,000
35,000
23,000
23,000
23,000
35,000
46,000
58,000
NPV
-$5,253.57
$2,424.27
$17,992.95
Decision
Reject
Accept
Accept
Project C is the best, followed by Project B. Project A is the worst project, and is unacceptable.
P8-8.
Erwin Enterprises has 10 million shares outstanding with a current market price of $10 per share.
There is one investment available to Erwin, and its cash flows are provided below. Erwin has a
cost of capital of 10 percent. Given this information, determine the impact on Erwins stock price
and firm value if capital markets fully reflect the value of undertaking the project.
Initial cash outflow = $10,000,000
Year Cash Inflow
1
$3,000,000
2
$4,000,000
3
$5,000,000
4
$6,000,000
5
$9,800,000
Renovate
Replace
$9,000,000 $1,000,000
3,500,000
600,000
3,000,000
500,000
3,000,000
400,000
13
4
5
2,800,000
2,500,000
300,000
200,000
NPV
$1,128,309
$433,779
IRR
20.5%
36%
The Renovate project has a higher NPV but the Replace project has a higher IRR.
a. Ranking on NPV: A, B
b. Ranking on IRR: B, A
c. The rankings provide mixed signals because of the differing cash flow patterns and initial
investments of the two projects. Projects that have lower initial investments and return their
cash flows earlier in the life of the project tend to have higher IRRs, as is the case with the
Replace project.
P8-13. A certain project has the following stream of cash flows:
Year
0
1
2
3
4
Cash Flow
$ 17,500
-80,500
138,425
-105,455
30,030
Project
NPV
______
______
______
______
______
______
______
______
______
b. Use the values developed in part a to draw a NPV profile for the project.
c. What is this projects IRR?
d. Describe the conditions under which the firm should accept this project.
A8-13.
a. Cost of
Capital
0
5
10
Project
NPV
0
-1.35
0
14
15
20
25
30
35
50
.56
0
-.672
0
3.46
41.48
c. The project has an IRR at every point where it crosses the discount rate axis, in this case at
0%, 10%, 20% and 30%.
d. This project is acceptable at discount rates greater than 30%, when the NPV is positive.
b.
Project NPV
50
40
30
20
Project NPV
10
0
-10
10
P8-15. You have a $10 million capital budget and must make the decision about which investments your
firm should accept for the coming year. Use the following information on three mutually
exclusive projects to determine which investment your firm should accept. The firms cost of
capital is 12 percent.
Project 1
Project 2
Project 3
Initial cash outflow
-$4,000,000
-$5,000,000
-$10,000,000
Year 1 cash inflow
1,000,000
2,000,000
4,000,000
Year 2 cash inflow
2,000,000
3,000,000
6,000,000
Year 3 cash inflow
3,000,000
3,000,000
5,000,000
a. Which project do you accept on the basis of NPV?
b. Which project do you accept on the basis of PI?
c. If these are the only investments available, which one do you select?
A8-15. a.
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c. Although Project #2 provides more bangs for the buck as represented by its higher PI,
Project #3 should be accepted since it has the higher NPV and there are no other investments
under consideration.
P8-17. Butler Products has prepared the following estimates for an investment it is considering. The
initial cash outflow is $20,000, and the project is expected to yield cash inflows of $4,400 per
year for seven years. The firm has a 10 percent cost of capital.
a. Determine the NPV for the project.
b. Determine the IRR for the project.
c. Would you recommend that the firm accept or reject the project? Explain your answer.
A8-17. Year
0
Cash Flow -$20,000
1
4,400
2
4,400
3
4,400
4
4,400
5
4,400
6
4,400
7
4,400
16