,SOLUTION MANUAL FOR Investment Analysis and Portfolio Management
12th Edition Reilly
Important Notes
The file includes the complete test bank, organized chapter by chapter.
A sample of selected pages has been provided for preview.
All available appendices and Excel files (if included in the original resources) are
provided.
We continuously update our files to ensure you receive the latest and most accurate
editions.
New editions are added regularly – stay connected for updates!
✅ Why Buy From Us?
📚 Complete & organized chapter-by-chapter – no missing content, no guessing.
⚡ Instant digital delivery – get your file the moment you pay, no waiting.
📅 Always up to date – we track new editions so you always get the latest version.
💬 Friendly support – real humans ready to help, anytime you need us.
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💰 Money-Back Guarantee: Not satisfied? We offer a full refund – no questions asked.
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correct version, free of charge.
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Contact Email:
, Solution and Answer Guide: Frank K. Reilly, Keith, C. Brown, Sanford J. Leeds, Investment Analysis & Portfolio Management, 12th
Edition, © 2025, 9780357988176; Chapter 1: The Investment Setting
Solution and Answer Guide
FRANK K. REILLY, KEITH, C. BROWN, SANFORD J. LEEDS, INVESTMENT ANALYSIS & PORTFOLIO
MANAGEMENT, 12TH EDITION, © 2025, 9780357988176; CHAPTER 1: THE INVESTMENT SETTING
TABLE OF CONTENTS
Answers to Questions ................................................................................................................ 1
Answers to Problems..................................................................................................................5
Appendix 1: Answers to Problems............................................................................................9
ANSWERS TO QUESTIONS
1. When an individual’s current money income exceeds his or her current consumption desires,
he or she saves the excess. Rather than keeping these savings in his or her possession, the
individual may consider it worthwhile to forego immediate possession of the money for a
larger future amount of consumption. This trade-off of present consumption for a higher level
of future consumption is the essence of investment.
An investment is the current commitment of funds for a period of time in order to derive a
future flow of funds that will compensate the investor for the time value of money and the
expected rate of inflation over the life of the investment, as well as provide a premium for the
uncertainty associated with this future flow of funds.
2. Students in general tend to be borrowers because they are typically not employed and thus
have no income (or they are employed with limited income), but they obviously consume
and have expenses. The usual intent is to invest the money borrowed in order to increase
their future income stream from employment. In other words, students expect to receive a
better job and higher income due to their investment in education.
3. In the 20–30-year-old segment, an individual would tend to be a net borrower because s/he
is in a relatively low-income bracket and has several expenditures, including automobile(s)
and durable goods. In the 30–40-year-old segment, an individual would likely dissave, or
borrow, as his or her expenditures would increase with the advent of family life, and
conceivably, the purchase of a house. In the 40–50-year-old segment, the individual would
probably be a saver because income would increase substantially with no increase in
expenditures. Between the ages of 50 and 60, the individual would typically be a strong
saver because income would continue to increase and by now the couple would be “empty-
nesters.” After this, depending upon when the individual retires, the individual would
probably be a dissaver as income decreases (transition from a regular income to income
from a pension). Of course, the earlier that this individual can start saving, the better off s/he
will be. Your goal should be to start saving once you finish school.
4. The saving–borrowing pattern would vary by profession to the extent that compensation
patterns vary by profession and time spent in school also varies. For most white-collar
© 2025 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly 1
accessible website, in whole or in part.
, Solution and Answer Guide: Frank K. Reilly, Keith, C. Brown, Sanford J. Leeds, Investment Analysis & Portfolio Management, 12th
Edition, © 2025, 9780357988176; Chapter 1: The Investment Setting
professions (for example, lawyers), income would tend to increase with age. Thus, lawyers
would tend to be borrowers in the early segments (when income is low) and savers later in
life. Alternatively, for blue-collar professions (for example, plumbers), in which skill is often
physical, compensation tends to remain constant or decline with age. Thus, plumbers would
tend to be savers in the early segments and dissavers in the later segments (when their
income declines).
5. The difference is because of the definition and the measurement of return. In the case of the
Wall Street Journal, they only refer to the current dividend yield on common stocks, whereas
in the case of the University of Chicago studies, they talk about the total rate of return on
common stocks, which is the dividend yield plus the capital gain or loss yield during the
period. In the long run, the dividend yield has been 4–5 percent, and the capital gain yield
has averaged about the same. In recent years, the dividend yield has been closer to 2
percent (and the amount of share repurchases has increased). Therefore, it is important to
compare alternative investments based on total return.
6. The variance of expected returns represents a measure of the dispersion of actual returns
around the expected value. Everything else remaining constant, the larger the variance is,
the greater the dispersion of expectations and the greater the uncertainty, or risk, of the
investment. The purpose of the variance is to help measure and analyze the risk associated
with a particular investment. A greater variance implies a greater possibility of returns that
are very different from your expected return—and that is risk.
7. An investor’s required rate of return is a function of the economy’s risk-free rate (RFR), an
inflation premium that compensates the investor for the loss of purchasing power, and a risk
premium that compensates the investor for taking the risk. The RFR is the pure time value of
money and is the compensation an individual demands for deferring consumption. More
objectively, the RFR can be measured in terms of the long-run real growth rate in the
economy because the investment opportunities available in the economy influence the RFR.
We think of Treasury yields (i.e., the cost of government borrowing) as the RFR. The
inflation premium is the additional protection an individual requires to compensate for the
erosion in purchasing power resulting from increasing prices. Because the return on all
investments is not certain as it is with T-bills, the investor requires a premium for taking on
additional risk. The risk premium can be examined in terms of business risk, financial risk,
liquidity risk, exchange rate risk, and country risk.
8. The three main factors that influence the nominal RFR are the real growth rate of the
economy, the expected rate of inflation, and liquidity (i.e., supply and demand for capital in
the economy). The real growth rate and inflationary expectations have positive relationships
with the nominal RFR. In other words, the higher the real growth rate, the higher the nominal
RFR, and the higher the expected level of inflation, the higher the nominal RFR. Liquidity
has an inverse relationship with the nominal RFR, meaning that lower liquidity results in
higher yields.
It is unlikely that the economy’s long-run real growth rate will change dramatically during a
business cycle. However, liquidity depends upon the government’s monetary policy and
would change depending upon what the government considers to be the appropriate
stimulus. Besides, the demand for business loans would be greatest during the early and
© 2025 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly 2
accessible website, in whole or in part.
, Solution and Answer Guide: Frank K. Reilly, Keith, C. Brown, Sanford J. Leeds, Investment Analysis & Portfolio Management, 12th
Edition, © 2025, 9780357988176; Chapter 1: The Investment Setting
middle parts of the business cycle. Inflation can also change significantly during a business
cycle.
9. The five factors that influence the risk premium on an investment are business risk, financial
risk, liquidity risk, exchange rate risk, and country risk.
Business risk is a function of sales volatility and operating leverage, and the combined effect
of the two variables can be quantified in terms of the coefficient of variation of operating
earnings. Financial risk is a function of the uncertainty introduced by the financing mix. The
inherent risk involved is the inability to meet future contractual payments (interest on bonds,
etc.) or the threat of bankruptcy. Financial risk is measured in terms of a debt ratio (for
example, debt/equity ratio) and/or the interest coverage ratio. Liquidity risk is the uncertainty
an individual faces when he or she decides to buy or sell an investment. The two
uncertainties involved are: (1) how long it will take to buy or sell this asset and (2) what price
will be received. The liquidity risk on different investments can vary substantially (for
example, real estate versus T-bills). Exchange rate risk is the uncertainty of returns on
securities acquired in a different currency. The risk applies to the global investor or
multinational corporate manager who must anticipate returns on securities in light of
uncertain future exchange rates. A good measure of this uncertainty would be the absolute
volatility of the exchange rate or its beta with a composite exchange rate. Country risk is the
uncertainty of returns caused by the possibility of a major change in the political or economic
environment of a country. The analysis of country risk is much more subjective and must be
based on the history and current environment in the country.
10. The increased use of debt increases the fixed interest payment. Since this fixed contractual
payment will increase, the residual earnings (net income) will become more variable. The
required rate of return on the stock will increase since the financial risk (as measured by the
debt/equity ratio) has increased.
11. According to the Capital Asset Pricing Model (which will be discussed in later chapters), all
securities are located on the Security Market Line, with securities’ risk on the horizontal axis
and securities’ expected return on the vertical axis. As to the locations of the five types of
investments on the line, the U.S. government bonds should be located to the left of the other
four, followed by the U.K. government bonds, low-grade corporate bonds, common stock of
large firms, and common stocks of Japanese firms. The U.S. government bonds have the
lowest risk and the required rate of return simply because they virtually have no default risk
at all. The U.K. government bonds are perceived to be default risk-free but expose the U.S.
investor to exchange rate risk. Low-grade corporates contain business, financial, and
liquidity risks but should be lower in risk than equities. Japanese stocks are riskier than U.S.
stocks due to exchange rate risk.
© 2025 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly 3
accessible website, in whole or in part.
, Solution and Answer Guide: Frank K. Reilly, Keith, C. Brown, Sanford J. Leeds, Investment Analysis & Portfolio Management, 12th
Edition, © 2025, 9780357988176; Chapter 1: The Investment Setting
12. An investor seeks a return that gives him or her a real rate of return plus compensation for
inflation. If a market’s real RFR is, say, 3 percent, then the investor will require a 3 percent
return on an investment because this will compensate him or her for deferring consumption.
If there is no expected inflation, both the real and the nominal RFR would be 3 percent.
However, if the expected inflation rate is 4 percent, the investor would be worse off in real
terms if he or she invests at a rate of return of 3 percent. For example, you would receive
$103, but the cost of $100 worth of goods at the beginning of the year would be $104 at the
end of the year, which means that you could consume less real goods. Thus, for an
investment to be desirable, it should have a return of 7.12 percent or an
approximate return of 7 percent (3% + 4%). In other words, you must receive both a real
rate of return (3 percent) and compensation for inflation (4 percent).
13. Both changes cause an increase in the required return on all investments. Specifically, an
increase in the real growth rate will cause an increase in the economy’s RFR because of a
higher level of investment opportunities. In addition, the increase in the rate of inflation will
result in an increase in the nominal RFR. Because both changes affect the nominal RFR,
they will cause an equal increase in the required return on all investments of 5 percent.
The following graph shows a parallel shift upward in the capital market line of 5 percent.
14. Such a change in the yield spread would imply a change in the market risk premium
because, although the risk levels of bonds remain relatively constant, investors have
© 2025 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly 4
accessible website, in whole or in part.
, Solution and Answer Guide: Frank K. Reilly, Keith, C. Brown, Sanford J. Leeds, Investment Analysis & Portfolio Management, 12th
Edition, © 2025, 9780357988176; Chapter 1: The Investment Setting
changed the spreads they demand to accept this risk. In this case, because the yield spread
(risk premium) declined, it implies a decline in the slope of the SML, as shown in the
following graph. This also implies that there would be a lower risk premium for stocks. With a
lower required rate of return, you would expect stock prices to increase.
15. The ability to buy or sell an investment quickly without a substantial price concession is
known as liquidity. An example of a liquid investment asset would be a United States
Government Treasury Bill. A T-bill can be bought or sold in minutes at a price almost
identical to the quoted price. In contrast, an example of an illiquid asset would be a
specialized machine or a parcel of real estate in a remote area. In both cases, it might take
a considerable period of time to find a potential seller or buyer, and the actual selling price
could vary substantially from expectations.
ANSWERS TO PROBLEMS
1.
2.
3. $4,000 used to purchase 80 shares = $50 per share
4.
© 2025 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly 5
accessible website, in whole or in part.
, Solution and Answer Guide: Frank K. Reilly, Keith, C. Brown, Sanford J. Leeds, Investment Analysis & Portfolio Management, 12th
Edition, © 2025, 9780357988176; Chapter 1: The Investment Setting
5(a).
Stock T is more desirable because the arithmetic mean annual rate of return is higher.
5(b).
© 2025 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly 6
accessible website, in whole or in part.
, Solution and Answer Guide: Frank K. Reilly, Keith, C. Brown, Sanford J. Leeds, Investment Analysis & Portfolio Management, 12th
Edition, © 2025, 9780357988176; Chapter 1: The Investment Setting
By this measure, B would be preferable.
5(c).
By this measure, T would be preferable.
5(d).
Stock T has more variability than Stock B. The greater the variability of returns, the
greater the difference between the arithmetic and geometric mean returns.
6.
7.
8. Lauren’s range of possible returns is much wider ranging from -0.60 to 0.80 than that of
Madison (from -0.10 to 0.25). The expected return is also higher for Lauren at 0.16 than that
of Madison at 0.075. It presents a greater risk than the Madison Beer Company as an
investment.
9.
© 2025 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly 7
accessible website, in whole or in part.
, Solution and Answer Guide: Frank K. Reilly, Keith, C. Brown, Sanford J. Leeds, Investment Analysis & Portfolio Management, 12th
Edition, © 2025, 9780357988176; Chapter 1: The Investment Setting
10.
(An approximation would be the growth rate plus the inflation rate or 0.03 + 0.04 = 0.07.)
11.
(An approximation would be 0.03 + 0.04 + 0.05 = 0.12 or 12%.)
As an investor becomes more risk averse, the investor will require a larger risk premium to
own common stock. As risk premium increases, so too will the required rate of return. In order
to achieve a higher rate of return, stock prices should decline.
12.
(An approximation would be 0.03 + 0.05 = 0.08.)
The required rate of return on common stock is equal to the RFR plus a risk premium.
Therefore, the approximate risk premium for common stocks implied by these data is 0.14 -
0.0815 = 0.0585 or 5.85%.
(An approximation would be 0.14 - 0.08 = 0.06.)
APPENDIX 1: ANSWERS TO PROBLEMS
1(a). Expected Return = S(Probability of Return)(Possible Return)
© 2025 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly 8
accessible website, in whole or in part.
12th Edition Reilly
Important Notes
The file includes the complete test bank, organized chapter by chapter.
A sample of selected pages has been provided for preview.
All available appendices and Excel files (if included in the original resources) are
provided.
We continuously update our files to ensure you receive the latest and most accurate
editions.
New editions are added regularly – stay connected for updates!
✅ Why Buy From Us?
📚 Complete & organized chapter-by-chapter – no missing content, no guessing.
⚡ Instant digital delivery – get your file the moment you pay, no waiting.
📅 Always up to date – we track new editions so you always get the latest version.
💬 Friendly support – real humans ready to help, anytime you need us.
🔒 Safe & secure – thousands of satisfied students trust us every semester.
🛡️Our Guarantees
💰 Money-Back Guarantee: Not satisfied? We offer a full refund – no questions asked.
🔄 Wrong File? No Problem: Contact us and we will replace it immediately with the
correct version, free of charge.
⏰ 24/7 Support: We are always here – reach out anytime and expect a fast response.
Contact Email:
, Solution and Answer Guide: Frank K. Reilly, Keith, C. Brown, Sanford J. Leeds, Investment Analysis & Portfolio Management, 12th
Edition, © 2025, 9780357988176; Chapter 1: The Investment Setting
Solution and Answer Guide
FRANK K. REILLY, KEITH, C. BROWN, SANFORD J. LEEDS, INVESTMENT ANALYSIS & PORTFOLIO
MANAGEMENT, 12TH EDITION, © 2025, 9780357988176; CHAPTER 1: THE INVESTMENT SETTING
TABLE OF CONTENTS
Answers to Questions ................................................................................................................ 1
Answers to Problems..................................................................................................................5
Appendix 1: Answers to Problems............................................................................................9
ANSWERS TO QUESTIONS
1. When an individual’s current money income exceeds his or her current consumption desires,
he or she saves the excess. Rather than keeping these savings in his or her possession, the
individual may consider it worthwhile to forego immediate possession of the money for a
larger future amount of consumption. This trade-off of present consumption for a higher level
of future consumption is the essence of investment.
An investment is the current commitment of funds for a period of time in order to derive a
future flow of funds that will compensate the investor for the time value of money and the
expected rate of inflation over the life of the investment, as well as provide a premium for the
uncertainty associated with this future flow of funds.
2. Students in general tend to be borrowers because they are typically not employed and thus
have no income (or they are employed with limited income), but they obviously consume
and have expenses. The usual intent is to invest the money borrowed in order to increase
their future income stream from employment. In other words, students expect to receive a
better job and higher income due to their investment in education.
3. In the 20–30-year-old segment, an individual would tend to be a net borrower because s/he
is in a relatively low-income bracket and has several expenditures, including automobile(s)
and durable goods. In the 30–40-year-old segment, an individual would likely dissave, or
borrow, as his or her expenditures would increase with the advent of family life, and
conceivably, the purchase of a house. In the 40–50-year-old segment, the individual would
probably be a saver because income would increase substantially with no increase in
expenditures. Between the ages of 50 and 60, the individual would typically be a strong
saver because income would continue to increase and by now the couple would be “empty-
nesters.” After this, depending upon when the individual retires, the individual would
probably be a dissaver as income decreases (transition from a regular income to income
from a pension). Of course, the earlier that this individual can start saving, the better off s/he
will be. Your goal should be to start saving once you finish school.
4. The saving–borrowing pattern would vary by profession to the extent that compensation
patterns vary by profession and time spent in school also varies. For most white-collar
© 2025 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly 1
accessible website, in whole or in part.
, Solution and Answer Guide: Frank K. Reilly, Keith, C. Brown, Sanford J. Leeds, Investment Analysis & Portfolio Management, 12th
Edition, © 2025, 9780357988176; Chapter 1: The Investment Setting
professions (for example, lawyers), income would tend to increase with age. Thus, lawyers
would tend to be borrowers in the early segments (when income is low) and savers later in
life. Alternatively, for blue-collar professions (for example, plumbers), in which skill is often
physical, compensation tends to remain constant or decline with age. Thus, plumbers would
tend to be savers in the early segments and dissavers in the later segments (when their
income declines).
5. The difference is because of the definition and the measurement of return. In the case of the
Wall Street Journal, they only refer to the current dividend yield on common stocks, whereas
in the case of the University of Chicago studies, they talk about the total rate of return on
common stocks, which is the dividend yield plus the capital gain or loss yield during the
period. In the long run, the dividend yield has been 4–5 percent, and the capital gain yield
has averaged about the same. In recent years, the dividend yield has been closer to 2
percent (and the amount of share repurchases has increased). Therefore, it is important to
compare alternative investments based on total return.
6. The variance of expected returns represents a measure of the dispersion of actual returns
around the expected value. Everything else remaining constant, the larger the variance is,
the greater the dispersion of expectations and the greater the uncertainty, or risk, of the
investment. The purpose of the variance is to help measure and analyze the risk associated
with a particular investment. A greater variance implies a greater possibility of returns that
are very different from your expected return—and that is risk.
7. An investor’s required rate of return is a function of the economy’s risk-free rate (RFR), an
inflation premium that compensates the investor for the loss of purchasing power, and a risk
premium that compensates the investor for taking the risk. The RFR is the pure time value of
money and is the compensation an individual demands for deferring consumption. More
objectively, the RFR can be measured in terms of the long-run real growth rate in the
economy because the investment opportunities available in the economy influence the RFR.
We think of Treasury yields (i.e., the cost of government borrowing) as the RFR. The
inflation premium is the additional protection an individual requires to compensate for the
erosion in purchasing power resulting from increasing prices. Because the return on all
investments is not certain as it is with T-bills, the investor requires a premium for taking on
additional risk. The risk premium can be examined in terms of business risk, financial risk,
liquidity risk, exchange rate risk, and country risk.
8. The three main factors that influence the nominal RFR are the real growth rate of the
economy, the expected rate of inflation, and liquidity (i.e., supply and demand for capital in
the economy). The real growth rate and inflationary expectations have positive relationships
with the nominal RFR. In other words, the higher the real growth rate, the higher the nominal
RFR, and the higher the expected level of inflation, the higher the nominal RFR. Liquidity
has an inverse relationship with the nominal RFR, meaning that lower liquidity results in
higher yields.
It is unlikely that the economy’s long-run real growth rate will change dramatically during a
business cycle. However, liquidity depends upon the government’s monetary policy and
would change depending upon what the government considers to be the appropriate
stimulus. Besides, the demand for business loans would be greatest during the early and
© 2025 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly 2
accessible website, in whole or in part.
, Solution and Answer Guide: Frank K. Reilly, Keith, C. Brown, Sanford J. Leeds, Investment Analysis & Portfolio Management, 12th
Edition, © 2025, 9780357988176; Chapter 1: The Investment Setting
middle parts of the business cycle. Inflation can also change significantly during a business
cycle.
9. The five factors that influence the risk premium on an investment are business risk, financial
risk, liquidity risk, exchange rate risk, and country risk.
Business risk is a function of sales volatility and operating leverage, and the combined effect
of the two variables can be quantified in terms of the coefficient of variation of operating
earnings. Financial risk is a function of the uncertainty introduced by the financing mix. The
inherent risk involved is the inability to meet future contractual payments (interest on bonds,
etc.) or the threat of bankruptcy. Financial risk is measured in terms of a debt ratio (for
example, debt/equity ratio) and/or the interest coverage ratio. Liquidity risk is the uncertainty
an individual faces when he or she decides to buy or sell an investment. The two
uncertainties involved are: (1) how long it will take to buy or sell this asset and (2) what price
will be received. The liquidity risk on different investments can vary substantially (for
example, real estate versus T-bills). Exchange rate risk is the uncertainty of returns on
securities acquired in a different currency. The risk applies to the global investor or
multinational corporate manager who must anticipate returns on securities in light of
uncertain future exchange rates. A good measure of this uncertainty would be the absolute
volatility of the exchange rate or its beta with a composite exchange rate. Country risk is the
uncertainty of returns caused by the possibility of a major change in the political or economic
environment of a country. The analysis of country risk is much more subjective and must be
based on the history and current environment in the country.
10. The increased use of debt increases the fixed interest payment. Since this fixed contractual
payment will increase, the residual earnings (net income) will become more variable. The
required rate of return on the stock will increase since the financial risk (as measured by the
debt/equity ratio) has increased.
11. According to the Capital Asset Pricing Model (which will be discussed in later chapters), all
securities are located on the Security Market Line, with securities’ risk on the horizontal axis
and securities’ expected return on the vertical axis. As to the locations of the five types of
investments on the line, the U.S. government bonds should be located to the left of the other
four, followed by the U.K. government bonds, low-grade corporate bonds, common stock of
large firms, and common stocks of Japanese firms. The U.S. government bonds have the
lowest risk and the required rate of return simply because they virtually have no default risk
at all. The U.K. government bonds are perceived to be default risk-free but expose the U.S.
investor to exchange rate risk. Low-grade corporates contain business, financial, and
liquidity risks but should be lower in risk than equities. Japanese stocks are riskier than U.S.
stocks due to exchange rate risk.
© 2025 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly 3
accessible website, in whole or in part.
, Solution and Answer Guide: Frank K. Reilly, Keith, C. Brown, Sanford J. Leeds, Investment Analysis & Portfolio Management, 12th
Edition, © 2025, 9780357988176; Chapter 1: The Investment Setting
12. An investor seeks a return that gives him or her a real rate of return plus compensation for
inflation. If a market’s real RFR is, say, 3 percent, then the investor will require a 3 percent
return on an investment because this will compensate him or her for deferring consumption.
If there is no expected inflation, both the real and the nominal RFR would be 3 percent.
However, if the expected inflation rate is 4 percent, the investor would be worse off in real
terms if he or she invests at a rate of return of 3 percent. For example, you would receive
$103, but the cost of $100 worth of goods at the beginning of the year would be $104 at the
end of the year, which means that you could consume less real goods. Thus, for an
investment to be desirable, it should have a return of 7.12 percent or an
approximate return of 7 percent (3% + 4%). In other words, you must receive both a real
rate of return (3 percent) and compensation for inflation (4 percent).
13. Both changes cause an increase in the required return on all investments. Specifically, an
increase in the real growth rate will cause an increase in the economy’s RFR because of a
higher level of investment opportunities. In addition, the increase in the rate of inflation will
result in an increase in the nominal RFR. Because both changes affect the nominal RFR,
they will cause an equal increase in the required return on all investments of 5 percent.
The following graph shows a parallel shift upward in the capital market line of 5 percent.
14. Such a change in the yield spread would imply a change in the market risk premium
because, although the risk levels of bonds remain relatively constant, investors have
© 2025 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly 4
accessible website, in whole or in part.
, Solution and Answer Guide: Frank K. Reilly, Keith, C. Brown, Sanford J. Leeds, Investment Analysis & Portfolio Management, 12th
Edition, © 2025, 9780357988176; Chapter 1: The Investment Setting
changed the spreads they demand to accept this risk. In this case, because the yield spread
(risk premium) declined, it implies a decline in the slope of the SML, as shown in the
following graph. This also implies that there would be a lower risk premium for stocks. With a
lower required rate of return, you would expect stock prices to increase.
15. The ability to buy or sell an investment quickly without a substantial price concession is
known as liquidity. An example of a liquid investment asset would be a United States
Government Treasury Bill. A T-bill can be bought or sold in minutes at a price almost
identical to the quoted price. In contrast, an example of an illiquid asset would be a
specialized machine or a parcel of real estate in a remote area. In both cases, it might take
a considerable period of time to find a potential seller or buyer, and the actual selling price
could vary substantially from expectations.
ANSWERS TO PROBLEMS
1.
2.
3. $4,000 used to purchase 80 shares = $50 per share
4.
© 2025 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly 5
accessible website, in whole or in part.
, Solution and Answer Guide: Frank K. Reilly, Keith, C. Brown, Sanford J. Leeds, Investment Analysis & Portfolio Management, 12th
Edition, © 2025, 9780357988176; Chapter 1: The Investment Setting
5(a).
Stock T is more desirable because the arithmetic mean annual rate of return is higher.
5(b).
© 2025 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly 6
accessible website, in whole or in part.
, Solution and Answer Guide: Frank K. Reilly, Keith, C. Brown, Sanford J. Leeds, Investment Analysis & Portfolio Management, 12th
Edition, © 2025, 9780357988176; Chapter 1: The Investment Setting
By this measure, B would be preferable.
5(c).
By this measure, T would be preferable.
5(d).
Stock T has more variability than Stock B. The greater the variability of returns, the
greater the difference between the arithmetic and geometric mean returns.
6.
7.
8. Lauren’s range of possible returns is much wider ranging from -0.60 to 0.80 than that of
Madison (from -0.10 to 0.25). The expected return is also higher for Lauren at 0.16 than that
of Madison at 0.075. It presents a greater risk than the Madison Beer Company as an
investment.
9.
© 2025 Cengage Learning, Inc. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly 7
accessible website, in whole or in part.
, Solution and Answer Guide: Frank K. Reilly, Keith, C. Brown, Sanford J. Leeds, Investment Analysis & Portfolio Management, 12th
Edition, © 2025, 9780357988176; Chapter 1: The Investment Setting
10.
(An approximation would be the growth rate plus the inflation rate or 0.03 + 0.04 = 0.07.)
11.
(An approximation would be 0.03 + 0.04 + 0.05 = 0.12 or 12%.)
As an investor becomes more risk averse, the investor will require a larger risk premium to
own common stock. As risk premium increases, so too will the required rate of return. In order
to achieve a higher rate of return, stock prices should decline.
12.
(An approximation would be 0.03 + 0.05 = 0.08.)
The required rate of return on common stock is equal to the RFR plus a risk premium.
Therefore, the approximate risk premium for common stocks implied by these data is 0.14 -
0.0815 = 0.0585 or 5.85%.
(An approximation would be 0.14 - 0.08 = 0.06.)
APPENDIX 1: ANSWERS TO PROBLEMS
1(a). Expected Return = S(Probability of Return)(Possible Return)
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