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CHAPTER 7, ACTIVITY #2: FORWARD LOOKING RETURN AND RISK
In this activity, you will model a forward-looking return and risk
scenario. You will then use Goal Seek to find a break-even probability.
An analyst tracks the pharmaceutical firm MannKind Corporation
(TICKER: MNKD). The company has just launched an insulin spray that
might change the diabetes drug market. Of course, it might not either.
The current stock price for MannKind is $5.50. The analyst has created
four possible outcomes for the new insulin spray in the next year based
on consumer demand. The consumer demand will influence the
inventory that MannKind must carry. His assumptions are shown below:
DEMAND:
STOCK PRICE
PROBABILITY
High Demand ---
Additional production needed
$11.00
10%
Good Demand ---
At capacity
$8.50
25%
Average Demand ---
Too Much Inventory
$5.75
40%
Poor Response ---
Overinvestment
$2.50
25%
As you can see, the analyst is not encouraged at MannKind’s prospects. Here is what you need to model for this activity:
Returns for each demand outcome
Expected return based on probability
Variance and standard deviation based on probability
Find probability needed to reach return
Here are the steps needed:
STEP 1.
Use the one-period return model to find the returns for each
level of demand.
STEP 2.
Use the SUMPRODUCT formula to find the expected return for
investing.
STEP 3.
Create a column of squared deviations (return for demand –
expected return)^2.
STEP 4.
Use SUMPRODUCT to find the variance of returns.
STEP 5.
Convert the variance to a standard deviation.
STEP 6.
Let’s assume that the analyst feels Mannkind must generate a
15% return to be worth the risk. If he feels good about the
probabilities, what price must MannKind sell at the high
demand case to reach a 15% expected return? (HINT: Use
Goal Seek to set the expected return cell equal to 15%, by
changing the future stock price if demand is high.)
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Related Questions
Which of the following statements is most correct?
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If you form a large portfolio of stocks each with a beta greater than 1.0, this portfolio will have more market risk than a single stock with a beta = 0.8.
Company-specific risk can be reduced by forming a large portfolio, but normally even highly diversified portfolios are subject to market risk.
Answers a, b, and c are correct.
Answers b and c are correct.
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a. Not be perfectly positively correlated
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True or False
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a.
the risk premiums of Stock H and L would increase by the same amount.
b.
the risk premium of Stock L would increase by more.
c.
the risk premiums of Stock H and L would remain unchanged.
d.
the risk premium of Stock H would increase by more.
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D. Not enough Information
Justify your choice in a sentence or two:
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Select one:
a. 3.28
b.
3.01
c. 4.09
d. 3.89
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QUESTION 1
Elizabeth has decided to form a portfolio by putting 30% of her money into stock 1 and 70% into stock 2. She assumes that the expected returns will be 10% and 18%, respectively, and that the standard deviations will be 15% and 24%, respectively.
Compute the standard deviation of the returns on the portfolio assuming that the two stocks' returns are uncorrelated.
17.4%.
27.4%.
7.4%.
11.4%.
QUESTION 2
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Describe what happens to the standard deviation of the portfolio returns when the coefficient of correlation ρ decreases.
The standard deviation of the portfolio returns decreases as the coefficient of correlation decreases.
The standard deviation of the portfolio returns increases as the coefficient…
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Discuss the difference in the profits associated with each option. Provide an example of real-world options that might generate such profit streams.
Which option has the greatest present value?
Option
Year 1
Year 2
Year 3
A
RM70,000
RM80,000
RM90,000
B
RM50,000
RM90,000
RM100,000
C
RM30,000
RM100,000
RM115,000
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