(A)
Case Summary:
The finance committee of an endowment fund decides to shift part of its investment in an index fund to a portfolio which is professionally managed. Upon investigation by a committee member, he proposes to choose a portfolio which has greater alpha value.
Characters in the case: A Committee member
Adequate Information: Alpha Value which is a performance ratio to help an investor evaluate risk-adjusted performance of a portfolio.
To determine if the proposed portfolio with greater alpha value should be chosen.
Explanation of Solution
Given Information:
The committee member proposes to choose an investment portfolio which has greater alpha value. Only this ratio will not help to determine the performance of the portfolio. Alpha along with Sharpe ratio is often used to rank the performance an investment portfolio.
Alpha is a ratio which reflects the performance of an investment relative to benchmark index which means that a positive alpha shows that the fund has beaten benchmark by 1% and so higher the alpha, better the fund. But alpha is just a number and expressed in percentage so alpha along with Sharpe ratio is used to determine the performance of the investment on risk-adjusted basis. Sharpe ratio helps to determine the real return on each unit of portfolio. Higher the ratio, better the return on investment and thus in turn better the investment.
Thus to conclude, a positive alpha alone cannot determine the performance of the investment portfolio to give the Sharpe measure higher than the benchmark.
(B)
To determine if positive alpha shows the performance of the portfolio is inferior.
Introduction: Alpha is a performance measure of an investment relative to benchmark index which means a positive alpha has beaten the benchmark index and so better the fund while Sharpe ratio along with alpha helps to determine the real performance of the portfolio.
Answer to Problem 1PS
A positive alpha can be associated with inferior performance of a portfolio if the Sharpe ratio has decreased.
Explanation of Solution
A positive alpha shows the performance of the portfolio relative to its benchmark while the Sharpe ratio shows the real return on each unit of investment. Thus it might be that the alpha is positive but Sharpe ratio has declined. This will in turn reflect inferior performance of the investment.
Therefore, yes it is true that a positive alpha may reflect inferior performance of the investment
Want to see more full solutions like this?
Chapter 18 Solutions
EBK ESSENTIALS OF INVESTMENTS
- Refer to the data for Eccles Inc. earlier. If the effective personal tax rates on debt income and stock income are Td = 25% and TS = 20% respectively, what is the value of the firm according to the Miller model (Based on the same unlevered firm value in the earlier question)? a. $475,875 b. $536,921 c. $587,750 d. $623,050 O $564,167arrow_forwardWarren Supply Inc. wants to use debt and common equity for its capital budget of $800,000 in the coming year, but it will not issue any new common stock. It is forecasting an EPS of $3.00 on its 500,000 outstanding shares of stock and is committed to maintaining a $2.00 dividend per share. Given these constraints, what percentage of the capital budget must be financed with debt? a. 33.84% b. 37.50% c. 32.15% d. 30.54% e. 35.63%arrow_forwardEccles Inc., a zero-growth firm, has an expected EBIT of $100.000 and a corporate tax rate of 30%. Eccles uses $500,000 of 12.0% debt, and the cost of equity to an unlevered firm in the same risk class is 16.0%. What is the firm's cost of equity according to MM with corporate taxes? Ο 32.0% Ο 25.9% Ο 21.0% Ο 28.8% Ο 23.3%arrow_forward
- P&L Corporation wants to sell some 20-year, annual interest, $1,000 par value bonds. Its stock sells for $42 per share, and each bond would have 75 warrants attached to it each exercisable into one share of stock at an exercise price of $47. The firm's straight bonds yield 10%. Each warrant is expected to have a market value of $2.00 given that the stock sells for $42. What coupon interest rate must the company set on the bonds in order to sell the bonds with-warrants at par? a. 9.54% b. 8.65% c. 9.08% d. 8.24% e. 83%arrow_forwardPotter & Lopez Inc. just sold a bond with 50 warrants attached. The bonds have a 20-year maturity and an annual coupon of 12%, and they were issued at their $1,000 par value. The current yield on similar straight bonds is 15%. What is the implied value of each warrant? Ο $4.35 O $3.76 O $4.56 O $4.14 O $3.94arrow_forwardIf a firm adheres strictly to the residual dividend policy, the issuance of new common stock would suggest that The dividend payout ratio is decreasing. The dividend payout ratio has remained constant. The dollar amount of investments has decreased. No dividends were paid during the year. the dividend payout ratio is increasing.arrow_forward
- q6) Which of the following statements is CORRECT? If Congress increases taxes on capital gains but leaves tax rates on dividends unchanged, this will motivate companies to increase stock repurchases. The clientele effect explains why firms change their dividend policies so often.. One advantage of the residual dividend policy is that it helps corporations to develop a specific and well-identified dividend clientele. If a firm splits its stock 2-for-1, then its stock price will be doubled. If a firm follows the residual dividend policy, then a sudden increase in the number of profitable projects is likely to reduce the firm's dividend payout.arrow_forwardAmold Rossiter is a 40-year-old employee of the Barrington Company who will retire at age 60 and expects to live to age 75. The firm has promised a retirement income of $20.000 at the end of each year following retirement until death. The firm's pension fund is expected to earn 7 percent annually on its assets and the firm uses 7% to discount pension benefits. What is Barrington's annual pension contribution to the nearest dollar for Mr. Rossiter? (Assume certainty and end-of-year cash flows. a. $3,642 b.$4,443 c. $4,967 d.$5,491 e.$2,756arrow_forwardMorales Publishing's tax rate is 40%, its beta is 1.10, and it uses no debt. However, the CFO is considering moving to a capital structure with 30% debt and 70% equity. If the risk free rate is 5.0% and the market risk premium is 6.0%, by how much would the capital structure shift change the firm's cost of equity? Ο 1.53% Ο 2.05% Ο 1.70% Ο 1.87% O 2.26%arrow_forward
- The common stock of Southern Airlines currently sells for $33, and its 8% convertible debentures (issued at par, or $1,000) sell for $850. Each debenture can be converted into 25 shares of common stock at any time before 2025. What is the conversion value of the bond? a. $825.00 b.$866.25 c. $744.56 d. $783.75 e. $707.33arrow_forwardBailey and Sons has a levered beta of 1.10, its capital structure consists of 40% debt and 60% equity, and its tax rate is 40%. What would Bailey's beta be if it used no debt, i.e., what is its unlevered beta? a. 0.79 b. 0.71 c. 0.67 d. 0.64 e. 0.75arrow_forwardEccles Inc., a zero-growth firm, has an expected EBIT of $100.000 and a corporate tax rate of 30%. Eccles uses $500,000 of 12.0% debt, and the cost of equity to an unlevered firm in the same risk class is 16.0%. What is the value of the firm according to MM with corporate taxes? a. $710,875 b. $587,500 c. $646,250 d. $475,875 e. $528,750arrow_forward
Essentials Of InvestmentsFinanceISBN:9781260013924Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.Publisher:Mcgraw-hill Education,
Foundations Of FinanceFinanceISBN:9780134897264Author:KEOWN, Arthur J., Martin, John D., PETTY, J. WilliamPublisher:Pearson,
Fundamentals of Financial Management (MindTap Cou...FinanceISBN:9781337395250Author:Eugene F. Brigham, Joel F. HoustonPublisher:Cengage Learning
Corporate Finance (The Mcgraw-hill/Irwin Series i...FinanceISBN:9780077861759Author:Stephen A. Ross Franco Modigliani Professor of Financial Economics Professor, Randolph W Westerfield Robert R. Dockson Deans Chair in Bus. Admin., Jeffrey Jaffe, Bradford D Jordan ProfessorPublisher:McGraw-Hill Education