Question

​Reward-to-risk ratio. The Uptown Investment Club has​ $50,000 to invest in the equity market. Chandler advocates investing the funds in​ Monica's Restaurant with a beta of 1.5 and an expected return of 16.7​%. Ross advocates investing the funds in​ Rachel's Clothing Store with a beta of 0.9 and an expected return of 15.0​%. The club is split​ 50/50 on the two stocks. You are the deciding​ vote, and you cannot pick a split of​ $25,000 for each stock. Before you​ vote, you look up the current​ risk-free rate​ (the one-year U.S. Treasury bill with a yield of 4.00​%). Which stock do you​ select?

Answer 1

Answer:

Rachel's clothing is the preferred stock as it has a higher reward-to-risk ratio

Explanation:

Using the formula for reward-to-risk ratio, the stock with a higher reward-to-risk ratio is more profitable stock and should be chosen

Reward-to-risk ratio=Expected return-risk free rate/beta

For Monica's restaurant :

expected return is 16.7%

risk free rate is 4.00%

beta is 1.5

Reward-to-risk ratio=(16.7%-4.00%)/1.5

                               =8.47%

For Rachel's clothing reward-to-risk ratio is calculated thus:

expected return is 15%

risk free rate of return is 4.00%

beta is 0.9

reward-to-risk =(15.00%-4.00%)/0.9

                       =12.22%