Problem 6.8

The Saimoldstuff Restaurant chain is considering building a specialty restaurant that will feature a new line designed for health-conscious diners. (The menu line will consist primarily of a choice of various vitamin and mineral supplement tablets accompanied by either a carrot juice cocktail or Himalayan spring water.) The managers of Saimoldstuff have estimated the following probability distribution of returns for the new restaurant:

State of Economy                                                         Probability                             Return

Boom                                                                                          .3                                      30%

Moderate recovery                                                               .4                                      20%

Recession                                                                                  .3                                      -10%

The managers have also determined that the E (k_m) is 18% and R. is 10%.

Required:

1.       What is the expected return of the of the new restaurant?

2.       In trying to evaluate the riskiness of the new restaurant. Saimoldstuff’s managers have found an existing restaurant with publicly traded shares that is an exact duplicate of the proposed restaurant. In evaluating the risk of this identical restaurant, the managers have determined that the restaurant’s return increase by 20% when the market portfolio’s return increases by 10%. Similarly when the market return fails by 10%, the restaurant return fall by 20%. If this relationship holds for all return combinations, what is the beta of the existing restaurant?

3.       Given your answer in question 2 above, and the Saimoldstuff’s new restaurant will have the same level of non-diversifiable risk as the existing restaurant, what rate of return will Saimoldstuff’s owners require on the investment in the new restaurant?

4.       Given your previous answer should Saimoldstuff’s managers invest in the restaurant? Explain precisely why or why not.