Problem: An investment fund has total capital of $500 million invested in 5 stocks:
STOCK INVESTMENT STOCK'S BETA COEFFICIENT
A $60 million 0.5
B $120 million 2.0
C $80 million 4.0
D $80 million 1.0
E $60 million 3.0
The beta coefficient for the fund can be found as a weighted average of the fund's investments. The current risk-free rate is 6%, whereas market returns have the following estimated probability distribution for the next period:
PROBABILITY MARKET RETURN
0.1 ---------- 7%
0.2 ---------- 9%
0.4 ---------- 11%
0.2 ---------- 13%
0.1 ---------- 15%
a. What is the estimated equation for the Security Market Line (SML)?
b. Compute the fund's required rate of return for the next period.
c. Assume that Jose Croesact, the fund's president, receives a proposal for a new stock. The investment needed to take a position in the stock is $50 million, it would have an expected return of 15%, and its estimated beta coefficient is 2.0. Should the new stock be purchased?
d. At what expected rate of return should the fund be indifferent to purchasing the stock?
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