Fin415 Problem Set 1

Risk Management Problem, Set I

FIN/415

Risk Management Problem, 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 the security?

Probability | Return |

.15 | 6% |

.30 | 9% |

.40 | 10% |

.15 | 15% |

Expected Rate of Return:

(.15 x .06) + (.30 x .09) + (.40 x .1) + (.15 x .15) .009 + .027 + .04 + .0225=.0985 or 9.85%

Standard Deviation:

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

Carter should concentrate on investing in this security because the expected return is obviously much higher than the 1-year treasury.

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 pre-assigned 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 pre-assigned required rates of return are as follows:

Purpose Required Rate of Return

Replacement decision 12%

Modification or expansion of existing product line 15

Project unrelated to current operations 18

Research and development operations 20

Determine each project's risk-adjusted net present value.

Project...