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Module 3 – Case Risk, Return, and Stock Valuation

Module 3 – Case

Risk, Return, and Stock Valuation

Assignment Overview

For this assignment, Questions 1, 3, and 5 are computational in nature. Questions 2 and 4 are conceptual questions. So make sure to thoroughly review the required background readings and make sure you understand the material at a conceptual level and also understand the steps involved in the computations.

For computational questions, you are not required to use Excel, but make sure to show all of your steps as part of your Word document. If you decide to use Excel, attach your spreadsheet in addition to a Word document with your answers. For conceptual questions, make sure to thoroughly explain the reasoning behind your answer and to use references from the required background reading.

Case Assignment

Submit your answers to the following questions in a Word document that includes both your computational steps in Questions 1, 3, and 5, and thoroughly explains your reasoning for Questions 2 and 4:

  1. Using a dividend discount model, what is the value of a stock that pays an annual dividend of $5 that is not expected to grow and the discount rate is 10%? What will be the value of the stock if the dividend is expected to grow 5% per year?
  2. Explain whether each of the following is systematic or unsystematic risk using references to the required background readings:
    1. There is a large recession.
    2. It is discovered that a company lied about its earnings and it is not nearly as profitable as they claimed.
    3. The CEO of a successful company gets arrested for some serious crimes, and the company has trouble finding a good replacement.
  3. Use the CAPM to calculate the following:
    1. The expected return of a stock with a beta of 2, and risk-free rate of 1%, and a market return of 7%.
    2. The beta if the expected return of the stock is 8%, the risk-free rate is 2%, and the market rate of return is 6%.
  4. Do you think the following companies would have a high, low, or average beta? Explain your answer using references from the background readings and your knowledge of CAPM and beta:
    1. The ACME Umbrella company’s stock goes up a lot when it rains, but goes down when it is sunny. Nothing else but the weather seems to impact ACME’s stock price.
    2. Vultures, Inc., specializes in buying assets of bankrupt companies at a discount. Vultures’ stock price seems to go up whenever other companies are doing poorly and going bankrupt, but goes down when other companies are doing well and they have few bankrupt companies to prey on.
    3. Unoriginal, Inc., can never decide what products they want to focus on so they make many different products in several different industries. They also invest much of their profits into 100 or so other companies that are listed on the stock exchange.
  5. Suppose the Tweedledee Company has an average return of 18%, and the Tweedledum Company has an average return of 10%. They both have a standard deviation of return of 10%, but Tweedledee has a beta of 2 and Tweedledum has a beta of 1. The risk-free rate is 1%. What are the Treynor and Sharpe Ratios of these two companies? What do these ratios tell you about the relative risk and return of these two companies?

Assignment Expectations

  Answer the assignment questions directly.

  • Stay focused on the precise assignment questions. Do not go off on tangents or devote a lot of space to summarizing general background materials.
  • For computational problems, make sure to show your work and explain your steps.
  • For short answer/short essay questions, make sure to reference your sources of information with both a bibliography and in-text citations. See the Student Guide to Writing a High-Quality Academic Paper, including pages 11-14 on in-text citations. Another resource is the “Writing Style Guide,” which is found under “My Resources” in the TLC Portal.


Module 3 – SLP

Risk, Return, and Stock Valuation

For your Module 3 SLP, we will go back to looking at information about the stock price and stock returns of your four companies. Look up the following information about your four companies on Yahoo Finance,, Morningstar, or a similar page:

  1. The current stock prices
  2. The stock prices five years ago
  3. The dividend yield for each stock
  4. The beta for each stock
  5. Look up the current three-month treasury bill rate on Fidelity’s Fixed Income page

Now do the following calculations with this information:

  1. Calculate the average annual capital gain or loss (stock price change) over the last five years. Calculate the percentage change from five years ago, and divide by five. For example, if the stock price increased from 50 to 100 in five years, the percentage increase would be 100% and the average annual gain would be 20% (100 divided by 5). Which of these companies has the highest or lowest capital gain?
  2. Now estimate the average total return, which is the capital gain plus dividends. If the dividend yield is 2%, then the average total return would be 22% in the example above. Which of these four companies has the highest or lowest total return? Does the order change?
  3. Finally, calculate the Treynor Ratio. First, take the total return for each of your four companies and subtract the three-month treasury bill rate (the “risk-free rate”). Then divide this by the beta of each company. This ratio is a measure of the risk-adjusted return of each stock. The higher the return, the higher the Treynor Ratio. But the higher the beta (which is a measure of risk), the lower the Treynor Ratio. Which of your companies has the highest or lowest risk-adjusted return? Does the order change from what you found in 1) and 2) above?

Submit a one-page memo in Word summarizing your findings, and include an Excel file with your data and calculations. 

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