CHAPTER 11 RISK AND EXPECTED RETURN

SUGGESTED SOLUTIONS
END OF CHAPTER QUESTIONS

11.1
(a) Linda Msepe: Bank investment
ROI = R450 / R3 000 X 100
= 15%
In terms of the Income Tax Act, a specified amount of interest earned is tax free, where after,
once that amount is exceed, tax is payable. If the interest is subject to tax in the hands of
Horace, his ROI will be
ROI = R450 (,7)/R3 000 X 100
= 10,5%

(b) Jo Naidoo: Sole proprietorship

ROI = R1 200 (,7)/R9 000
= 9,3%
The profits which are earned by a sole proprietorship are taxable in the hands of the owner.
Flo will also be taxed on her monthly salary.

(c) Maria Nkosi: Close corporation

ROI = R20 000 (,10) / R10 000
= 20%
Although no distribution of profits has been made, the profits, which have been reinvested in
the business represent a return on the original investment. As the CC has already been
subjected to tax, no tax is payable in the hands of the member Nicola, regardless of whether
the profits have been distributed or not.

(d) Peter Simpson: 200 shares

ROI = [240 + 200 (20-18)]/ (200 x R18)
= (240 + 400)/3 600
= 17,8%
Both the potential capital gain of R2 per share and the dividends received of R240 comprise a
return on Peter's investment. If he decided to sell his shares at the end of the year he would
realise income of R400 (capital gain) and R240 (dividends). The capital gain’s tax depends to
great extent on individual circumstances, and is unlikely to exceed 10% to 15% of the return.
His return on investment after capital gains tax is likely to be in the region of 14% to 15%.

11.2
There is no correct answer to this question and it forms a basis for discussion in order to
identify the principles, which underlie investment decisions. The first principle is that all
investments are dependant upon the required rate of return, which in turn depends on the risk
free rate (time value of money plus expected inflation rate at the time) plus the reward for the
risk of the particular investment. The starting point is to assume a reasonable risk free
rate – say 10%. [The variable part of this is totally dependant upon the current inflationary
expectations]. Thereafter, to add to that a premium that is considered to be an estimate of the
risk of each type of investment, relative to each other.
(a) This is a low risk investment, so a premium of around 2% to 3% is appropriate –
resulting in a required rate of return of 12% to 13%.
(b) Purchasing and owning a flat for lease offers two potential returns, one in the form of
the monthly rent received and the other in the form of the capital gain when the flat is
sold at a later date for a higher price. It is a relatively low risk investment and the
expected return is likely to be in the region of 15% to 20% p.a. [The calculation of
actual return on an annualised basis can only be done once the flat is sold].

© FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS 1

 (c) A general equity unit trust would be expected to deliver the average annual return on
equities. This, over the long term, is in the region of 12%, thus offering an expected
return of around 22%.
(d) Placing all your funds into a single share is more risky because of the absence of
diversification, and the expected return is thus fully dependant upon the fortunes of
that particular company. A retail chain store is relatively less risky than the average
return on all types of companies, thus the expectation is likely to be around 20%.
(e) The return on shares of an information technology company tend to be more variable
over time and therefore more risky than the average return on all types of companies,
lifting the required rate of return (the expected return which will induce an investor to
invest), to 25% and above.

11.3
Purchase price [share in DD] = R 960.00
Price one year later = R 840.00
Capital gain/loss = -R 120.00
% Return(loss) to shareholder = -12.50% (-110 / 950)
11.4
Expected returne R 3.20
Principal [Price] R 16.00 (320/.20)
11.5
Purchase price [share in Foschini] = R 7.70
Price one year later = R 8.60
Capital gain/loss = R 0.90
Dividend = R 0.90
Increase in wealth per share = R 1.80
% Return(loss) to shareholder = 23.38% (180 / 770)
11.6
Return in perpetuity = R 120
Required rate of return = 20.00%
Principal [Maximum investment] = R 600.00 (R120 /.2)
11.7

Principal Rate Time Interest

R 8,000 12.00% 8 years R 76.80
R 8,000 12.00% 8 months R 6.40
R 8,000 12.00% 8 days R 0.21
R 20,000 10.00% 3 years R 6,000
R 60,000 12.00% 10 years R 72,000
R 4,000 15.00% 152 days R 250
R 10,000 18.00% 40 months R 6,000

11.8

Principal = R 8,000
FV @ 12% for 9 years = 2.773
Future value = R 22,184.63

© FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS 2

11.9
Principal = R 250,000
FV @ 14% for 15 years = 7.138
Future value = R 1,784,484.49
11.10.
Future value required = R 40,000
PV @ 16% for 6 years = 0.410
Amount to invest now = R 16,417.69
11.11
Principal = R 7,500
FV @ 16% for 8 years = 3.278
Future value = R 24,588.11
11.12
Future value of an annuity R 70,000
FVA @ 16% for 5 years = 6.877
Annual instalments = R 10,178.66
11.13
Future value . = R 400,000
PV @ 10% for 15 years = 0.239
Amount to invest now = R 95,756.82
11.14
Annuity instalment = R 12,000
FVA @ 12% for 5 years = 6.353
Future value of the annuity = R 76,234.17
11.15
Annuity instalment for retirement = R 24,000
FVA @ 12% for 20 years = 72.052
Future value of the annuity = R 1,729,258.62
11.16
Future value to receive = R 12,000
PV @ 14% for 6 years = 0.456
Amount to invest now = R 5,467.04
11.17
Annual annuity required = R 8,000
PVA @10% for 10 years = 6.145
Amount to invest now = R 49,156.54 [if invested at the beginning of 1st year]
If first investment at end of year
PVA @10% for 9 years 5.759
Plus the first instalment immediately
withdrawn 1.000
Factor to use 6.759
Amount to invest at the end of
the first year R 54,072.19 [if invested at the end of 1st year]

© FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS 3

11.18
Annual annuity required = R 17,000
PVA @12% for 7 years = 4.564
Amount to invest now = R 77,583.86 [if invested at the beginning of 1st year]
If first investment at end of year
PVA @ 12% for 6 years 4.111
Plus the first instalment immediately
withdrawn 1.000
Factor to use 5.111
Amount to invest at the end of
the first year R 86,893.92 [if invested at the end of 1st year]
11.19
11.20
Annual annuity to be paid to Mortgagor = R 30,000
PVA @ 16% for 20 years = 5.929
Maximum amount of Mortgage Loan = R 177,865

Note the amount which will be repaid = R 600,000 [R30 000 x 20 years]
= 3.4 times the amount borrowed!!

Annual amount able to be repaid = R 24,000

PVA @ 15%
Instalment to befor 6 years
paid each year [5 years] == R3.784
5,000 on 18th to 22nd birthday
Maximum amount
PVA @ 10% for 5 yearsof Loan == 3.791
R 90,828
Amount needed in 7 years time = R 18,953.93 Note - this is invested on her 17th birthday
Note the amount which will be repaid = R 144,000 and used
[R30 for
000thex first
20 years]
annuity payment on
= 1.6 times the amount borrowed
her 18th birthday
PV @ 10% for 7 years = 0.513
Amount to be invested today = R 9,726.37
11.21

11.22

Required rate of return = Risk free Rate + Beta (Risk Premium)

Risk free rate = 12.00%
Beta = 1.4
Market return = 22.00%
Required rate of return = 26.00% 12% + 1.4(22%-12%)

© FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS 4

11.23

Annual income required = R 15,000

PVA @ 15% for 8 years = 4.487
Investment required now = R 67,310
11.24
Year NOW 1 2 3 4
Expected Dividends 65 cents 72 cents 80 cents 95 cents
Expected selling price 1 150 cents
Cash Flow [cents per share] 65 72 80 1245
PV factor @ 15% 0.8696 0.7561 0.6575 0.5718
Present Value 56.52 54.44 52.60 711.83
Highest price to pay [cents] 875.40
11.25

Year NOW 1 2 3
Expected Dividends 22 cents 24 cents 30 cents
Expected selling price 450 cents
Cash Flow [cents per share] 22 24 480
PV factor @ 18% 0.8475 0.7182 0.6086
Present Value 18.64 17.24 292.14
Highest price to pay [cents] 328.02
11.26
SCORES OBTAINED BY CLASS OF 30 STUDENTS
87 71 66 62 51 44
83 70 66 60 50 43
76 69 65 57 48 42
76 68 63 55 46 41
72 66 63 54 46 40
394 344 323 288 241 210
Aggregate [Sum of all 30 scores] = 1800
Mean = 60
[Sum of allnumbers divided by number of students]
Median = 62.5
[Number in the middle ie between 15th &16th number]
Mode = 66
[Number which recurs most frequently]

© FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS 5

11.27
YEAR RETURN YEAR RETURN YEAR RETURN YEAR RETURN
20.30 18% 20.25 8% 20.20 18% 20.15 7%
20.29 12% 20.24 10% 20.19 21% 20.14 13%
20.28 -2% 20.23 12% 20.18 15% 20.13 19%
20.27 8% 20.22 7% 20.17 -4% 20.12 23%
20.26 14% 20.21 8% 20.16 -3% 20.11 16%

50% 45% 47% 78%

10% 9% 9% 16%
Aggregate [Sum of all 20 returns] = 220%
Mean = 11%
[Sum of allnumbers divided by number of students]
Median = 12%
[Number in the middle ie between 10th &11th number]
Mode = 8%
[Number which recurs most frequently]

11.28

(a) Quarter Data Deviation Deviation2

QI 8 3 9
Q2 6 1 1
Q3 5 0 0
Q4 4 -1 1
Q5 7 2 4
Q6 0 -5 25
Q7 -2 -7 49
Q8 5 0 0
Q9 9 4 16
Q10 7 2 4
Q11 6 1 1
Q12 5 0 0
Sum 60 110
Mean 5
Variance 9.17 (110/12)
Std Dev 3.03 Square root of 9.17

(b) Probability of one standard deviaiton above the mean is (100 - 68)/2 = 16%

(c ) To calculate these prbabilities, we must use the Z score

Below (%) 5 = (5-5)/3.03
Z score = 0
Probability of earning below (or above) is exactly 50% (because 5% is
the Mean
Above (%) 10 = (10-5)/3.03
Z Score = 1.65
Table reading = 0.4505
Interpretation = .5000 - .4505
Probability of above 10% = 4.95%

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11.29
(a) Quarter Data Deviation Deviation2
QI 4 0 0
Q2 -2 -6 36
Q3 5 1 1
Q4 4 0 0
Q5 5 1 1
Q6 4 0 0
Q7 7 3 9
Q8 8 4 16
Q9 6 2 4
Q10 3 -1 1
Q11 7 3 9
Q12 -3 -7 49
Sum 48 126
Mean 4
(b) Variance 10.50 (126/12)
Std Dev 3.24 Square root of 10.5

(d) To calculate the probability, the Z score must be used

Higher (%) 4 = (4-4)/3.24
Z score = 0
Probability of earning below (or above) is exactly 50% (because 4%
is the Mean
Below (%) 0 = (0-4)/3.24
Z Score = -1.24
Table reading = 0.3925
Interpretation = .5000 - .3925
Probability of below 0% = 10.75%
(This is also the probability of capital invested being eroded)
11.30
Required rate of return = Risk free Rate + Beta (Risk Premium)
Risk free rate = 10.00%
Beta = 0.8
Market return = 18.00%
Required rate of return = 16.40% 10% + 0.8(18%-10%)
11.31
(a) Required [Expected] rate of return = Risk free Rate + Beta (Risk Premium)
Risk free rate [Govt Bond rate] = 8.00%
Beta of Stable Ltd = 1.1
Market return = 19.00%
Expected rate of return from Stabler Ltd = 20.10% 8% + 1.1(19%-8%)
(b) Expected Portfolio return = 14.05% (.5x8%)+(.5x20.1%)
Portfolio (50% in each) Beta = 1.1/2
= 0.55

© FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS 7

11.32

COMPARISON OF 2 SHARES
YEAR Rp Rq dp dq dp2 dq2
1 15 17 3 3 9 9
2 18 20 0 0 0 0
3 20 18 -2 2 4 4
4 17 23 1 -3 1 9
5 20 22 -2 -2 4 4
SUM 90 100 0 0 18 26
MEAN 18 20
VARIANCE 3.6 5.2
STD DEV 1.90 2.28

(c ) Consistent with market forces, share P has a lower expected return with lower risk than Share
Q. Selection between P or Q depends entirely upon the risk preference of the investor. Some
would prefer expecting 20% (share Q) with a lower probability of achieving it than expecting
18% with a higher chance of that being the return.

© FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS 8