Corporate Finance

Tutorial 4 Questions

Corporate Finance
Tutorial 4: Mean-Variance Analysis and CAPM
Questions
1.

2.

You are considering the purchase of 100 shares of Slick-Tex Incs common stock.
The historical beta on the security is 1.65 and the current market premium is
5.6%.
a.

If the riskless rate of interest is currently 12%, what will your required rate
of return be?

b.

Given the rate of return computed in part (a), an expected dividend of

$8.50 and a 5% growth rate, what value do you place on the stock?

Johnson Manufacturing Inc is considering several investments. The rate on

Treasury bills is currently 6.75%, and the expected return for the market is 12%.
What should be the required rates of return for each investment?
Security
A
B
C
D

3.

4.

Beta
1.50
0.82
0.60
1.15

An American investor owns 100 Microsoft shares and 650 shares of Bethlehem
Steel as a portfolio of 2 assets. The market price of the shares are $130 and $10
respectively. The total value of the portfolio is $19,500. The expected returns on
Microsoft and Bethlehem Steel are 10% p.a. and 16% p.a. respectively whereas
their variances are 25% and 49% respectively.
a)

Calculate the portfolio weight for each of the assets.

b)

Calculate the expected return on the portfolio.

c)

Calculate the portfolios variance if

i)

xy = 0

ii)

xy = 0.50

iii)

xy = 0.50

An investor forms a portfolio of two assets, X and Y. These assets have expected
returns of 9% and 6% and return variances of 64% and 36% respectively.
Assuming that the investor places a portfolio weight of 0.50 on each asset,
calculate the portfolio expected return and variance of the correlation between
returns on X and Y is unity.

Corporate Finance

Tutorial 4 Questions

5.

Using the data from Question 4, recalculate the portfolio expected return and
variance, assuming that the correlation between the returns is 0.50.

6.

An investor forms a portfolio from two assets, P and Q, using portfolio weights of
one-third and two-thirds respectively. The expected returns on P and Q are 5%
and 7%, and their respective return variances are 16% and 25%. Assuming the
return correlation is zero, calculate the expected return and variance of eth
investors portfolio.

7.

Assuming identical data to that in Question 6. Recalculate the statistical properties

of the portfolio, assuming the return correlation for P and Q is 0.50.

Sample Examination Question on Risk-Return: Mean-Variance Analysis & CAPM

1.

Detail the assumptions that underlie the CAPM and provide a derivation of the
CAPM equation. Support your derivation with graphical evidence. [15 marks]

2.

The returns on ABC stock and on the market portfolio in three consecutive years
are given in the following table:
Year
1
2
3

ABC Return
8%
24%
28%

Showing all workings, compute the beta for ABCs equity.

3.

Market Return
6%
12%
15%
[7 marks]

Assume that the risk free rate is five per cent. What is the expected return on
ABCs stock?
[3 marks]

Past Mock Exam Question

No matter which model a company uses as its basis for computing its cost of capital to
be used in the Investment Appraisal of future investments, be it the Gordon Dividend
Model, the Capital Asset Pricing Model (CAPM), or the Arbitrage Pricing Model (APM),
the appraisal model results are no better than guesswork. This is because some of the
values for the variables in each model for deriving the cost of capital are themselves
estimates.
Discuss and comment on this statement.

[25 marks]

Corporate Finance

Tutorial 4 Questions

Security Market Line Blackberry Plc and Apple Plc

Blackberry Plc and Apple Plc are two companies whose shares for several years have
been quoted on the London Stock Exchange at around 200p. Dividends each year have
been about 24p for Blackberry Plc and 16p for Apple Plc. Investment analysts explain
such differences in dividend yield by alluding to the risk of each company as measured
by its "beta coefficient".
Required:
a)

Explain what is meant by the beta coefficient and how it may be computed for
any particular company in practice.

b)

If the riskless rate of interest is assumed to be 5% and the current market return is
estimated at 10%, compute the beta coefficient for Blackberry Plc and Apple Plc.

c)

State briefly the characteristics of Blackberry Plc as opposed to Apple Plc as

determined by their beta coefficients.

d)

If the market rate of return fell to 8%, whilst the riskless rate remained at 5%,
calculate the new market equilibrium prices for Blackberry and Apple Plc
assuming that there was no change in expectations about dividends for either of
the two companies i.e. dividends are expected to remain at 24p and 16p per
annum respectively.

Corporate Finance

Tutorial 4 Questions

Portfolio Paul Folly

Paul Folly has $20,000 to invest in three alternative investments Hay Limited, Jay
Limited and Kay Limited. The expected returns from each of the investments in three
equally likely market conditions are given in the following table:
Rates of Return on Investment
Market
Condition
A
B
C

Probability of
Market Condition
1/3
1/3
1/3

Hay Ltd
0.30
0.18
0.06

Jay Ltd
0.24
0.12
0.00

Kay Ltd
0.15
0.12
0.09

Inter-company covariances of returns have been computed as follows:

Covariance Hay : Jay

0.0096

Covariance Hay : Kay

0.0024

Covariance Jay : Kay

0.0024

Required:
a)

Explain which one of the three investments Paul Folly would reject for investment
purposes.

b)

Explain as simply as possible the meaning of risk as assumed in portfolio theory.

What are the assumptions about the individuals attitude towards such risk?

Corporate Finance

Tutorial 4 Questions

Fresno plc
The accountant of Fresno plc has collected together the following information in order to
compute the equity cost of capital for the company. The companys share price at this
point in time is $2.49, having just gone ex-dividend, based in the announced 1995
dividend quoted below. Given below are the last five years dividends and earnings per
share for Fresno.
Year
1995
1994
1993
1992
1991

Dividend per Share

(cents)
41.50
40.00
39.00
36.00
34.14

Earnings per Share

(cents)
90.00
78.00
80.00
65.00
68.00

The accountant has obtained from a research agent the following information, that the
predicted risk free return for the next year is 8%, and based on other research, a return on
the market portfolio of 18% and a beta value for Fresno of 2.2 times. The accountant
intends to use the Gordon and CAPM methods to compute Fresnos equity cost of capital.
Required:
a)

Compute the equity cost of capital of Fresno separately using Gordon Dividend
Model (also known as the Dividend Growth Model) and the CAPM approaches.
[10 marks]

b)

Write a report explaining your results in Part (a) above and using the principles
behind the two methods explain any differences or similarities in the results you
obtained in Part (a) above.
[10 marks]

c)

Fresno is an all equity company. Using your findings in Part (a) recommend with
reasons to the financial director the cost of capital to be used in the companys
next investment appraisal evaluation.
[5 marks]

Corporate Finance

Tutorial 4 Questions

FE 2007 Zone B Question A1

a.

You consider an investment project which has an investment outlay of

100,000 and generates a risky cash flow of 28,000 each year for 5 years.
You estimate that the beta of the project is 1.2.The risk free rate of return is
5% and the expected rate of return on the market index is 10%. Should the
project be undertaken if you use a payback method of 4 years? Should it
be undertaken if you use an NPV method?
(12.5 marks)

b.

Describe what would happen to your conclusions in (a) if you realize that
your beta estimate of 1.2 is wrong: it should be 1.5 instead. What would
your recommended course of action be in this case, and why?
(12.5 marks)

Corporate Finance

Tutorial 4 Questions

FE 2007 Zone B Question A3

The risk free rate of return is 5% and the expected rate of return on the market
index is 10%. The variance of the return on the market index is 20%.
a.

Two portfolios A and B have expected return 7% and 15%, and variance
20% and 50%, respectively. Work out the portfolios beta coefficients.
(8 marks)

b.

The risk of a portfolio can be decomposed into market risk and

idiosyncratic risk. What are the proportions of market risk and
idiosyncratic risk for the two portfolios A and B?
(8 marks)

c.

Assume the two portfolios have uncorrelated idiosyncratic risk. What is

the covariance between the return on the two portfolios?
(9 marks)

Corporate Finance

Tutorial 4 Questions

FE 2008 Zone B Question A1

A project costs 100,000 and has an operating cash flow of 10,000 in the first two
years and 40,000 in the following three years. The project stops at the end of
year 5. The expected return on the market index is 12% and the risk free rate is
5%.
(a)

Using the payback rule, is this project worth while with a payback of 3
years? Discuss the advantages and disadvantages of the payback rule.
Would you go with the recommendations of the payback rule in this case?
Explain.
(5 marks)

(b)

Suppose the operating cash flow consists of both revenues and costs, and
suppose the expected revenue each year is 120% of the net expected
operating cash flow given above, while the expected costs each year are
20% of the net expected operating cash flow. You should assume that the
costs are uncorrelated with the movements of the market index. The
revenues have a beta of 0.75. Work out the NPV of the project.
(10 marks)

(c)

You are uncertain about the beta estimate of 0.75. The assets of the project
are very similar to the assets of a firm that is listed on the stock exchange.
The beta of the equity of this firm is 1.5, and the beta of the debt of the
firm is 0. The firm has 60% equity and 40% debt. Given the new
information, what is your estimate of the net present value now? In
answering this question you may ignore the information about the split
between costs and revenues given in (b).
(10 marks)

Corporate Finance

Tutorial 4 Questions

FE 2008 Zone B Question A3(c)

Consider a firm that has free cash flow of $200,000 each year for 5 years. At the
end of year 5 you expect the value of the firm is equal to the resale value of its
assets, which is $1,600,000. You believe it is appropriate to use a discount rate
which corresponds to a beta of 1. The expected return on the market index is
12%, and the risk free return is 5%. Work out the current value of the firm.
(10 marks)

Corporate Finance

Tutorial 4 Questions

FE 2008 Zone B Question A4

You consider an investment project which has a cost of $200,000. The cash flow
of the project is $20,000 per year, growing at a rate of 1% per year. The cash flow
is expected to continue indefinitely. The assets of the project has unknown beta,
but they are very similar to the assets of a company which has already a stock
market listing. This company has 50% debt and 50% equity, and the equity has a
beta of 1.2. The expected return on the market index is 12% and the risk free rate
is 5%.
(a)

If the project has a beta of 1, what is the net present value of the project?
(5 marks)

(b)

Use the listed company as a basis for working out the beta of the project.
What is the net present value of the project using this beta estimate?
(10 marks)

(c)

Suppose the listed company also owns valuable growth opportunities.

You estimate that 20% of the current value consists of growth
opportunities with beta 1, and 80% consists of assets similar to the assets
in your investment project. Would this change your conclusion in (b)?
Explain.
(10 marks)

10

Corporate Finance

Tutorial 4 Questions

FE 2009 Zone B Question A2 (a & b)

(a)

Prove that the variance of an equally weighted portfolio with a large

number (N) of stocks is the average covariance of each stock with each
other when N goes to infinity.
(8 marks)

(b)

You observe the returns of two companies for the last five years as
follows:
Year
1
2
3
4
5

Return on Company 1 (%)

3
4
8
0
10

Return on Company 2 (%)

-1
14
20
7
0

Given the figures above, determine the coefficient of correlation between

the returns of these two companies. What would be the weights you
allocate to these two companies if you would like to minimize the
portfolios risk?
(10 marks)

11

Corporate Finance

Tutorial 4 Questions

FE2009 Zone B Question A4

Suppose that you have estimated the expected returns and betas of the following
five stocks using annual data available for the last 10 years:
Stock
A
B
C
D
E

Market Capitalisation
($m)
360
23
250
10
500

Beta
0.6
0.8
1.2
1.3
1.4

Expected Return
(%)
8
10
11
12
12

The risk-free rate of interest and the expected return on the market are 5% and
10% per annum respectively. You are also told that the market size of companies
in this market is normally distributed with a mean of $400m and a standard
deviation of $150m.
(a)

Explain carefully the extend to which these data are consistent with
the Capital Asset Pricing Model (CAPM) and whether there is any
arbitrage strategy.
(9 marks)

(b)

What would you advise to an investor who would like to hold a

portfolio with a beta equals to 1?
(3 marks)

(c)

Empirically, small capitalized firms seem to have a higher expected

return than what the capital asset pricing model predicts. This
evidence is often regarded as an anomaly to the CAPM. Critically
assess whether this information alone casts doubt about the
validity of the CAPM and the market efficiency.
(13 marks)

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