REPORT ON

ALEX SHARPE’S PORTFOLIO

CASE STUDY

CORPORATE FINANCE-I
ASSIGNMENT - 2
MBA 2018-20

SUBMITTED BY
ANUSHA N
ARJUN S
KRISHNA KUMAR M
MATHUMITHA C S
INTRODUCTION:

Investing decisions are always hard, particularly for risk aversive investors. Alex Sharpe
has invested her children’s savings in Vanguard 500 fund. Sharpe wanted high returns and
has been considering adding stocks to her current equity portfolio.

Based on her research, she has narrowed down into two choices;

1. Hasbro (NYSE: HAS)

2. R.J Reynolds Tobacco Company (NYSE: RJR)

In order to find the risk and returns for her investing decision, CAPM is used as a tool to
analyse. The monthly returns of last five years data for Vanguard 500 Fund, Hasbro and R.J
Reynolds are provided.

CAPITAL ASSET PRICING MODEL:

The CAPM was introduced by William F. Sharpe (1964). The Capital Asset Pricing
Model (CAPM) describes the relationship between systematic risk and expected return for
assets, particularly stocks. CAPM is widely used throughout finance for pricing risky
securities and generating expected returns for assets given the risk of those assets and cost
of capital.

Where,

– Expected return of investment – Expected return of the market

– Risk free rate – Market risk premium

– Beta of the investment

The main aim of CAPM is to find whether a stock is valued fairly when the expected
return is compared to its risk and time value of money.

 The time value of money is given by the risk-free rate in CAPM formula.
 The beta is the measure of risk the investment will add to the portfolio.
 The market risk premium is the return expected from market above the risk free rate.

The graphical representation of the CAPM equation gives the Security Market Line.

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COMPARISON OF RETURN AND VARIABILITY:

1. Average Monthly Returns

S&P 500 – 0.57 %
R J Reynolds – 1.87 %
Hasbro – 1.18 %
2. The Expected Return

The expected return is found by summing up the total monthly returns, as we do

not have the probability.

S&P 500 = 0.57 %

R J Reynolds = 1.87 %
Hasbro = 1.18 %
3. Annualized Expected Return

Annualized Expected return =

For 5 years, the annualized expected return is

S&P 500 = 6.89 %

R J Reynolds = 22.50 %
Hasbro = 14.21 %

Taking into account all three returns, we can see that R J Reynolds gives high
percentage of returns. Now, to verify it along with the variability, standard
deviation of the individual stocks is found.

4. Risk – Standard Deviation

S&P 500 – 12.37 %

R J Reynolds – 32.17 %

Hasbro – 27.88 %

From the data arrived, we can see that R J Reynolds, gives us with high risk.
In terms of investing, high risk has the probability of high returns. Investors with
Risk Seeking nature, tend to go for stocks with higher risks expecting higher
returns.

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PORTFOLIO POSITION

With combinations of different investing decisions, Alex Sharpe looks into the
returns each combination gives. We vary the proportion ranging from 99%in S&P and 1%
in either Reynolds or Hasbro and as such.

1. Return:

Equity S&P + Reynolds S&P+ Hasbro

99% - 1% 0.587338333 0.580428333

90% - 10% 0.704383333 0.635283333

80% - 20% 0.834433333 0.696233333

70% - 30 % 0.964483333 0.757183333

60% - 40% 1.094533333 0.818133333

55% - 45% 1.159558333 0.848608333

40% - 60% 1.354633333 0.940033333

10% - 90% 1.744783333 1.122883333

1% - 99% 1.861828333 1.177738333

The various combinations gives us return ranging from 0.58 to 1.8

approximately. The higher returns are calculated when the investing percentage
is more in individual stocks. S&P and Reynolds give the best return even after
taking various combos.

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2. Annual Expected Return:

Equity S&P + Reynolds S&P+ Hasbro

99% - 1% 7.04806 6.96514

70% - 30 % 11.5738 9.0862

1% - 99% 22.34194 14.13286

S&P and Reynolds give the highest return with 1% in S&P 500 and 99% in
Reynolds. But we have to look into the risk before taking any decision.

3. Risk:

The risk is calculated by finding the standard deviation of the weighted returns.

Equity S&P + Reynolds S&P+ Hasbro

99% - 1% 0.035933187 0.036173816

70% - 30 % 0.042732784 0.044743781

1% - 99% 0.092830481 0.080574183

As we can see, higher the returns it gives higher risk too. Here, in the break-
up of 70% - 30%, Reynolds gives less risk than Hasbro, but the more we invest
in Reynolds’s, the risk shoots up along with the high returns.

So it’s better to stop at 70-30 S&P- Reynolds’s investment, where the risk is
lower and returns are higher.

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BETA COEFFICIENT:

The beta coefficient is the measure of risk that is added to the portfolio. The beta
coefficient is found by using the Regression Model.

The equation of the regression model is,

̂

Where, a is the intercept -

b is the slope –β

x is the independent variable – in our case, S&P 500 stock.

- Stock is riskier than market

- Reduces the risk of portfolio

The beta values are as follows:

S&P 500 + Reynolds’s - 0.735763036

S&P 500 + Hasbro - 1.419799452

The Reynolds’s stock gives lesser beta value, which implies that, when it is added to the
portfolio, it will reduce the risk of the portfolio.

CONCLUSION:

From the analysis performed, Alex Sharpe should add RJ Reynolds’s to her
portfolio, since it has lower risk and higher returns, in terms of individual stock and as a
portfolio. The beta value also indicates that, when RJ Reynolds’s is added to the portfolio, it
will reduce the overall risk and increase the returns.