Suppose you have invested only in two stocks, A and B. You expect that returns on the stocks depend on the following three states of economy, which are equally likely to happen.

State of economy | Return on Stock A (%) | Return on Stock B (%) |

Bull | 10% | 12% |

Normal | 6% | 4% |

Bear | 2% | -2% |

- Calculate the expected return of each stock.
- Calculate the standard deviation of returns of each stock.
- Calculate the covariance and correlation between the two stocks.

## Question 2

Suppose the current risk-free is 7 percent. Pandragon Limited stock has a beta of 1.8 and an expected return of 16% percent. (Assume the CAPM is true)

- What is the risk premium on the market?
- Ralph Industries stock has a beta of 1.8. What is the expected return on the Ralph Industries stock?
- Suppose you have invested RM100,000 in a stock portfolio of Pandragon Limited and Ralph Industries, and the beta of the portfolio is 1.77. How much did you invest in each stock? what is the expected return on the portfolio?

## Question 3

Sensor Berhad is considering undertaking a project but is considering whether Project A or Project B brings higher returns. The company has a cost of capital of 10%, and the cash flows of the projects are as follows:

Year | Project A (RM’000) | Project B (RM’000) |

0 | (300) | (300) |

1 | 75 | 80 |

2 | 90 | 80 |

3 | 85 | 90 |

4 | 120 | 100 |

5 | 120 | 100 |

- Calculate the NPV and IRR of Project A and Project B.
- Recommend the project that Sensor Berhad should take, considering the calculations in (a).
- Briefly explain the inconsistency of investment appraisal decisions when both NPV and IRR methods are used.

## Question 4

- Cycrus Berhad is going to pay a dividend of 20 cents per ordinary share and currently pays out 20% of earnings as dividends. They have an average rate of return (ARR) of 20% and their current share price is RM3.30. What is Cycrus Berhad’s cost of equity?
- Consider the following two stocks:

Stock | Expected return | Beta |

A | 20% | 2.4 |

B | 12% | 1.7 |

Assume the CAPM holds. Based upon the CAPM, what is the return on the market? What is the risk-free rate?

- The equity shares of Kenneth Limited have a beta value of 0.5. The risk-free rate of return is 8% and the market risk premium is 6%. Corporate tax is 20%. What is the required return on the shares?

## Question 5

What sort of investor rationally views the standard deviation (or variance) of an individual security’s return as the security’s proper measure of risk? What sort of investor rationally views the beta of security as the security’s proper measure of risk?