Textbook Case Problem Week 2

 This assignment is due Sunday 9.30 pm EST


Complete the following:

  • Case Problem 4.1 A-F (page 154)
  • Case Problem 4.2 A-D (page 155)
  • Case Problem 5.1 A-E (page 208)
  • Case Problem 5.2 A-E (page 209)
  • Case Problem 13.1 A-E (page 543)

Format your submission consistent with APA guidelines.

  • Case Problem 4.1 A-F (page 154)

Case Problem 4.1 Coates’s Decision

1.   LG 2

2.   LG 4

On January 1, 2017, Dave Coates, a 23-year-old mathematics teacher at Xavier High School, received a tax refund of $1,100. Because Dave didn’t need this money for his current living expenses, he decided to make a long-term investment. After surveying a number of alternative investments costing no more than $1,100, Dave isolated two that seemed most suitable to his needs.

Each of the investments cost $1,050 and was expected to provide income over a 10-year period. Investment A provided a relatively certain stream of income. Dave was a little less certain of the income provided by investment B. From his search for suitable alternatives, Dave found that the appropriate discount rate for a relatively certain investment was 4%. Because he felt a bit uncomfortable with an investment like B, he estimated that such an investment would have to provide a return at least 4% higher than investment A. Although Dave planned to reinvest funds returned from the investments in other vehicles providing similar returns, he wished to keep the extra $50 ($1,100 − $1,050) invested for the full 10 years in a savings account paying 3% interest compounded annually.

As he makes his investment decision, Dave has asked for your help in answering the questions that follow the expected return data for these investments.

Expected Returns
End of Year A B
2017 $   50 $  0
2018 $   50 $150
2019 $   50 $150
2020 $   50 $150
2021 $   50 $200
2022 $   50 $250
2023 $   50 $200
2024 $   50 $150
2025 $   50 $100
2026 $1,050 $ 50


a.   Assuming that investments A and B are equally risky and using the 4% discount rate, apply the present value technique to assess the acceptability of each investment and to determine the preferred investment. Explain your findings.

b.   Recognizing that investment B is more risky than investment A, reassess the two alternatives, adding the 4% risk premium to the 4% discount rate for investment A and therefore applying a 8% discount rate to investment B. Compare your findings relative to acceptability and preference to those found for question a.

c.    From your findings in questions a and b, indicate whether the IRR for investment A is above or below 4% and whether that for investment B is above or below 8%. Explain.

d.   Use the present value technique to estimate the IRR on each investment. Compare your findings and contrast them with your response to question c.

e.   From the information given, which, if either, of the two investments would you recommend that Dave make? Explain your answer.

f.     Indicate to Dave how much money the extra $50 will have grown to by the end of 2026, assuming he makes no withdrawals from the savings account.


Case Problem 4.2 A-D (page 155)

Case Problem 4.2 The Risk-Return Tradeoff: Molly O’Rourke’s Stock Purchase Decision

Over the past 10 years, Molly O’Rourke has slowly built a diversified portfolio of common stock. Currently her portfolio includes 20 different common stock issues and has a total market value of $82,500.

Molly is at present considering the addition of 50 shares of either of two common stock issues—X or Y. To assess the return and risk of each of these issues, she has gathered dividend income and share price data for both over the last 10 years (2007–2016). Molly’s investigation of the outlook for these issues suggests that each will, on average, tend to behave in the future just as it has in the past. She therefore believes that the expected return can be estimated by finding the average HPR over the past 10 years for each of the stocks. The historical dividend income and stock price data collected by Molly are given in the accompanying table.

Stock X Stock Y
Share Price Share Price
Dividend Dividend
Year Income Beginning Ending Income Beginning Ending
2007 $1.00 $20.00 $22.00 $1.50 $20.00 $20.00
2008 $1.50 $22.00 $21.00 $1.60 $20.00 $20.00
2009 $1.40 $21.00 $24.00 $1.70 $20.00 $21.00
2010 $1.70 $24.00 $22.00 $1.80 $21.00 $21.00
2011 $1.90 $22.00 $23.00 $1.90 $21.00 $22.00
2012 $1.60 $23.00 $26.00 $2.00 $22.00 $23.00
2013 $1.70 $26.00 $25.00 $2.10 $23.00 $23.00
2014 $2.00 $25.00 $24.00 $2.20 $23.00 $24.00
2015 $2.10 $24.00 $27.00 $2.30 $24.00 $25.00
2016 $2.20 $27.00 $30.00 $2.40 $25.00 $25.00


a.   Determine the HPR for each stock in each of the preceding 10 years. Find the expected return for each stock, using the approach specified by Molly.

b.   Use the HPRs and expected return calculated in question a to find the standard deviation of the HPRs for each stock over the 10-year period.

c.    Use your findings to evaluate and discuss the return and risk associated with stocks X and Y. Which stock seems preferable? Explain.

d.   Ignoring her existing portfolio, what recommendations would you give Molly with regard to stocks X and Y?


Case Problem 5.1 A-E (page 208)

Case Problem 2.1 Traditional Versus Modern Portfolio Theory: Who’s Right?

1.   LG 5

2.   LG 6

Walt Davies and Shane O’Brien are district managers for Lee, Inc. Over the years, as they moved through the firm’s sales organization, they became (and still remain) close friends. Walt, who is 33 years old, currently lives in Princeton, New Jersey. Shane, who is 35, lives in Houston, Texas. Recently, at the national sales meeting, they were discussing various company matters, as well as bringing each other up to date on their families, when the subject of investments came up. Each had always been fascinated by the stock market, and now that they had achieved some degree of financial success, they had begun actively investing.

As they discussed their investments, Walt said he thought the only way an individual who does not have hundreds of thousands of dollars can invest safely is to buy mutual fund shares. He emphasized that to be safe, a person needs to hold a broadly diversified portfolio and that only those with a lot of money and time can achieve independently the diversification that can be readily obtained by purchasing mutual fund shares.

Shane totally disagreed. He said, “Diversification! Who needs it?” He thought that what one must do is look carefully at stocks possessing desired risk-return characteristics and then invest all one’s money in the single best stock. Walt told him he was crazy. He said, “There is no way to measure risk conveniently—you’re just gambling.” Shane disagreed. He explained how his stockbroker had acquainted him with beta, which is a measure of risk. Shane said that the higher the beta, the more risky the stock, and therefore the higher its return. By looking up the betas for potential stock investments on the Internet, he can pick stocks that have an acceptable risk level for him. Shane explained that with beta, one does not need to diversify; one merely needs to be willing to accept the risk reflected by beta and then hope for the best.

The conversation continued, with Walt indicating that although he knew nothing about beta, he didn’t believe one could safely invest in a single stock. Shane continued to argue that his broker had explained to him that betas can be calculated not just for a single stock but also for a portfolio of stocks, such as a mutual fund. He said, “What’s the difference between a stock with a beta of, say, 1.2 and a mutual fund with a beta of 1.2? They have the same risk and should therefore provide similar returns.”

As Walt and Shane continued to discuss their differing opinions relative to investment strategy, they began to get angry with each other. Neither was able to convince the other that he was right. The level of their voices now raised, they attracted the attention of the company’s vice president of finance, Elinor Green, who was standing nearby. She came over and indicated she had overheard their argument about investments and thought that, given her expertise on financial matters, she might be able to resolve their disagreement. She asked them to explain the crux of their disagreement, and each reviewed his own viewpoint. After hearing their views, Elinor responded, “I have some good news and some bad news for each of you. There is some validity to what each of you says, but there also are some errors in each of your explanations. Walt tends to support the traditional approach to portfolio management. Shane’s views are more supportive of modern portfolio theory.” Just then, the company president interrupted them, needing to talk to Elinor immediately. Elinor apologized for having to leave and offered to continue their discussion later that evening.


a.   Analyze Walt’s argument and explain why a mutual fund investment may be overdiversified. Also explain why one does not necessarily have to have hundreds of thousands of dollars to diversify adequately.

b.   Analyze Shane’s argument and explain the major error in his logic relative to the use of beta as a substitute for diversification. Explain the key assumption underlying the use of beta as a risk measure.

c.    Briefly describe the traditional approach to portfolio management and relate it to the approaches supported by Walt and Shane.

d.   Briefly describe modern portfolio theory and relate it to the approaches supported by Walt and Shane. Be sure to mention diversifiable risk, undiversifiable risk, and total risk, along with the role of beta.

e.   Explain how the traditional approach and modern portfolio theory can be blended into an…

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