Assume that you recently graduated with a major in finance. You just landed a jo
ID: 1172311 • Letter: A
Question
Assume that you recently graduated with a major in finance. You just landed a job as a financial planner with Merrill Finch Inc., a large financial services corporation. Your first assignment is to invest $100,000 for a client. Because the funds are to be invested in a business at the end of 1 year, you have been instructed to plan for a 1-year holding period. Further, your boss has restricted you to the investment alternatives in the following table, shown with their probabilities and associated outcomes. (For now, disregard the items at the bottom of the data; you will fill in the blanks later.)
Note: The estimated returns of U.S. Rubber do not always move in the same direction as the overall economy. For example, when the economy is below average, consumers purchase fewer tires than they would if the economy was stronger. However, if the economy is in a flat-out recession, a large number of consumers who were planning to purchase a new car may choose to wait and instead purchase new tires for the car they currently own. Under these circumstances, we would expect U.S. Rubber’s stock price to be higher if there is a recession than if the economy is just below average. Merrill Finch’s economic forecasting staff has developed probability estimates for the state of the economy, and its security analysts developed a sophisticated computer program to estimate the rate of return on each alternative under each state of the economy. High Tech Inc. is an electronics firm; Collections Inc. collects past-due debts; and U.S. Rubber manufactures tires and various other rubber and plastics products. Merrill Finch also maintains a “market portfolio” that owns a market-weighted fraction of all publicly traded stocks; you can invest in that portfolio and thus obtain average stock market results. Given the situation described, answer the following question:
Why are High Tech’s returns expected to move with the economy, whereas Collections’s are expected to move counter to the economy?
High Eoomayrolbabiry 5. Market 2-Stock Portfolio Portfolio 0.0% ProbabilityT-BilTechCollestions Recession Below average Average Above average Boom 5.5% 5.5 5.5 5.5 5.5 (27096) | | 0.1 0.2 0.4 0.2 0.1 6,0% (7.0) 15.0 30.0 45.0 4.0) (30) 7.5 41.0 120 38.0 10.5 26.0 9.8% 0.0 188 | 3.4 i4 05 1.9 0.88 dv 13.2Explanation / Answer
The difference in return cycles for both companies lies in the difference in their businesses.
As given in question, High Tech Inc. is an electronics firm. While the economy grows, there would be more construction activities across the country - whether it is personal homes, business centres, factories and industries, etc. While these construction activities go up, the demand for the products of High Tech would also rise. This means their business owuld grow and their is a higher possibility of good income. And hence higher stock returns. However, if there is a slow down or recession, there would be less demand for electrical products (as people and corporatations would look to conserve their money) and hence the possibility of slow operating performance would be high. And hence lower stock returns.
Collections Inc collect past-due debts. Now, when the economy moves in recession, there would be more defaults in terms of delayed interest payments or companies going bankrupt and hence overall default on credit payback. This would actually mean more business generated for Collections Inc. during the recessionary phase. In the good economic growth times, the probability as well as number of defaults are lower. Hence, lower business for Collections Inc.