Chapter 11

Mr.
Mohamed Aljamri Tel: 39233646
Chapter 11- Additional Problems
Problem 1:
As the chief investment officer for a money management firm specializing in taxable individual
investors, you are trying to establish a strategic asset allocation for two different clients. You have
established that Ms. A has a risk-tolerance factor of 8, while Mr. B has a risk tolerance factor of
27. The characteristics for four model portfolios follow:
a. Calculate the expected utility of each prospective portfolio for each of the two clients.
b. Which portfolio represents the optimal strategic allocation for Ms. A? Which portfolio is
optimal for Mr. B? Explain why there is a difference in these two outcomes
c. For Ms. A, what level of risk tolerance would leave her indifferent between having
Portfolio 1 or Portfolio 2 as her strategic allocation? Demonstrate.
1|Page
Mr. Mohamed Aljamri Tel: 39233646
Problem 2:
Given the monthly returns that follow, how well did the passive portfolio track the S&P 500
benchmark? Find the R2, alpha, and beta of the portfolio. Compute the average return differential
with and without sign.
2|Page
Problem 3:
Betty Black's investment club wants to buy the stock of either NewSoft Inc. or Capital Corp. In
this connection, Black has prepared the following table. You have been asked to help her interpret
the data, based on your forecast for a healthy economy and a strong market over the next 12
months.
NewSoft's shares have higher price-earnings (PIE) and price-book (P/B) ratios than those of
Capital Corp. Identify and briefly discuss three reasons why the disparity in ratios may not indicate
that NewSoft's shares are overvalued relative to the shares of Capital Corp. Answer the question
in terms of the two ratios, and assume that there have been no extraordinary events affecting either
company
Answer
Reasons NewSoft shares may not be overvalued compared with shares of Capital Corporation
although NewSoft’s higher ratios of price to earnings (P/E) and ratios of price to book (P/B)
include:
Higher P/E
1. Prices reflect expected future earnings. If NewSoft’s earnings are growing faster than
those of Capital Corp., a higher P/E would be justified.
2. Different accounting practices. Accounting practices affect P/Es based on accounting

profits because companies often have different accounting practices (for example, LIFO/FIFO,
depreciation policy, and expense recognition). Historical accounting decisions (for example,
writeoffs) may also affect P/Es. Adjustments for such differences may be required before relative
valuations can be properly assessed.
3. Cyclical behavior. Given the cyclical nature of the capital goods sector, the P/E ratio for
Capital Corp. may have declined below its five-year average only because recent earnings have
risen to a level that analysis indicates is unsustainable.
3|Page
4. Difference between accounting and economic profits. Accounting profits used to calculate
P/Es can differ from economic profits and may or may not be sustainable. NewSoft’s earnings
performance may be understated (for example, by expensing noncash items such as goodwill).
Capital Corp.’s earnings performance may be overstated (for example, by using low-cost tiers of
LIFO inventory).
5. Differences in industries. Different industries have different valuation levels given by the
market. NewSoft is a technology company, but Capital Corp. is a capital goods company.
6. Young versus mature industries. Industries at different points in their life cycles will have
different valuations. Young industries often have higher valuations.
Higher P/B
1 . Off-balance-sheet assets. NewSoft may have significant off-balance-sheet assets that are
reflected in its stock price but not in its book value. P/Bs have little interpretive value in situations
in which intellectual property and human capital are key aspects to company success (for example,
the software industry). Physical plant and equipment are typically small, resulting in high P/Bs.
2. Nature of assets. Although physical plant and equipment presumably are a larger portion of
Capital Corp.’s total value, the nature of its assets will also affect the validity of using book value
as a measure of economic value. Assets such as goodwill and plant and equipment may vary greatly
in their balance sheet cost versus economic value. For example, Capital Corp.’s balance sheet may
include significant goodwill, which raises the company’s book value but not its stock price.
3. Efficient use of assets. The P/B does not show how efficiently either company is using its
assets. To the extent that NewSoft is generating a higher margin of profit with its assets, a higher
P/B may be justified.
4. Obsolete assets. Some of Capital Corp.’s assets may be functional but obsolete. The
company’s lower P/B may merely reflect the limited market value of its plant and equipment and
the prospective costs of replacement.
4|Page

Chapter 11

Uploaded by

Copyright:

Available Formats

Chapter 11

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Chapter 11

Uploaded by

Copyright:

Available Formats

Mr.

Mohamed Aljamri Tel: 39233646

Chapter 11- Additional Problems

2. Different accounting practices. Accounting practices affect P/Es based on accounting

You might also like