Tom Johnson wants to invest in a portfolio of common stocks selected below. He e
ID: 2785681 • Letter: T
Question
Tom Johnson wants to invest in a portfolio of common stocks selected below. He expects the returns for the five stocks he has chosen to be as follows:
Stock Expected Return Beta
Dow Chemical 12.8% 1.20
Time Warner 12.6% 1.15
Google 12.6% 1.145
Tesla 13.6% 1.39
Micron Technology 13.0% 1.23
According to his best estimates, the expected return on a well-diversified portfolio of common stocks is 12 percent annually and the risk-free rate of return is 8 percent annually.
A. Is each stock in equilibrium? Explain your answer and show any calculations you make.
B. Mr. Johnson will invest equal dollar amounts in each stock. Calculate the portfolio beta and the expected return on the portfolio. Show your calculations.
C. Why would Mr. Johnson want to invest in a portfolio like this one made up of high beta stocks? Explain.
Explanation / Answer
A. Expected return on Dow Chemical is (according to CAPM) = Rf + Beta *(Rm-Rf)
= 8% + 1.2*(12%-8%) = 8% + 4.8% = 12.8%
So Dow chemical is in equilibrium since expected return is its stated return
Similarly, expected return of Time Warner is 8% + 1.15*4% = 12.6% (It is in Equilibrium)
Expected return of Google = 8% + 1.145*4% = 12.58% (it is in equilibrium, neglecting the rounding error)
Expected return of Tesla = 8% +1.39*4% = 13.56% (It is in Equilibrium)
Expected return of Micron Technology = 8% + 4**1.23 = 12.92% (It is almost in Equilibrium)
B. Lets say Mr. Johnson invests $1000 in each of the stocks. Then its $5000 ($1000 in each stock) will be worth $1128 + 1126 + 1126 + 1136 + 1130 = $5,646 which is a profit of $646 on $5000 OR a return of 12.92%
Portfolio Beta is calculated by using CAPM
12.92% = 8% + Beta*4%
Beta = 1.23
C. Mr. Johnson would invest in a portfolio like this one made up of high beta stocks as he wasnt higher returns. Please note that, though he will get higher return, his risk will also be more.