Chapter 4 Financial Risk and Required Return PROBLEM 1 Cons

		Chapter 4 -- Financial Risk and Required Return
PROBLEM 1
Consider the following probability distribution of returns estimated for a proposed project that involves a
new ultrasound machine:
	State of the	Probability	Rate of
	Economy	of occurrence	Return
	Very poor	0.1	-10%
	Poor	0.2	0%
	Average	0.4	10%
	Good	0.2	20%
	Very good	0.1	30%
a. What is the expected rate of return on the project?
b. What is the project\'s standard deviation of returns?
c. What is the project\'s coefficient of variation (CV) of returns?
d. What type of risk does the standard deviation and CV measure?
e. In what situation is this risk relevant?
ANSWER

Solution

state of economy probability(p) rate of return-r p*r p*r*r very poor 0.1 -0.1 -0.01 0.001 poor 0.2 0 0 0 average 0.4 0.1 0.04 0.004 good 0.2 0.2 0.04 0.008 very good 0.1 0.3 0.03 0.009 0.1 0.022 0.012 Expected rate of return on the project 0.1 standard deviation of returns 0.109545 coefficient of variation 1.095445 This allows to determinehow much volatilitywe are assuming in comarison to the amount of return that can expect from investment The risk is relavent when analyzing investments that have differentexpected rates of return and different levels of risk