Finance

Assignment at end of book

Questions Solutions

Copy 2019

Dr. heba Wahba

CPA – CIA – CMA
01114364363
1- Define finance? Explain how this field affects the lives of everyone and
every organization.
Finance is the art and science of managing money. Finance affects all individuals ,
businesses, and governments in the process of the transfer of money through
institutions , markets , and instruments.

2- What are the main principles of finance discussed in this chapter ?

An Egyptian pound received today worth more than an

Egyptian pound received in the future. On the other hand, an
Egyptian pound received in the future is worth less than an
Egyptian pound received today.

Individuals would not take on additional risk unless they

expect to be compensated with additional return.
This principal is based on the concept that individuals are risk-
averse

is an accounting concept designed to measure a firm’s

performance over a period of time.
is the amount of cash that actually be taking out of
the firm over the same period

Investors act to new information through buying and selling

investments. The efficiency of the market determines by the
speed with which investors reply and the way that prices
respond to the information

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3- What are the primary activities of the financial manager ? what are the
two views to classify financial decisions discussed in this textbook?
(1) determining both the most efficient level and
the best mix of assets ; and
(2) establishing and maintaining the proper mix of
short – and long term financing and raising needed financing in the most
economical fashion.
Financial activities/decisions can be classified according to the following two
views or perspectives:
The first view or perspective of the classifications of financial decisions states that
the primary activities of the financial manager, in addition to ongoing involvement
in financial analysis and planning, are making investment decisions and making
financing decisions.
In turn, investment decision can be classified in two groups: short investment
decisions (related to current assets) and long investment decisions (related to long
term assets). In general, investment decisions totally related to the left-hand side
of the balance sheet
 Through making investment decisions,

 Determine both the mix and the type of assets found on the firm's
balance sheet.
 Determine the best chances to invest their funds so as to create a high
level of expected return so wealth of corporate owners can be
maximized (capital budgeting decision). In general, financing
decisions totally related to the right-hand side of the balance sheet
Also, financing decisions can be classified in two groups: short-term financing
decisions (related to current liabilities) and- long-term financing decisions (related
to long term liabilities and stockholders' equity).
 Through making financing decisions
:
 Determine the appropriate mix of short-term and long-term financing.
 Deciding which individual short-term sources are best at a given point
in time.
 Deciding which individual long-term sources are best at a given point
in time.
 Determine the appropriate mix of long-term financing to maximize
the value of the firm (capital structure decisions).
 Determine the financial requirements (additional financing needs).
This view can be represented in the following.

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 - Short-term Assets - Short-term liabilities
 Short-term Investments  Short-term sources of funds
Short-term Investment Decisions Short-term financing decisions

- Non-current assets / Fixed - Long-term liabilities

Assets Stockholders equity
 Long-term Investments  Long-term sources of funds
Long-term Investment Decisions Long-term financing decisions
Total Assets = Total Liabilities + Stockholders Equity,

Long term assets + Current Assets = Current Liabilities +Long Term Liabilities +
Stockholders Equity
of the classifications of financial decisions states
that the primary activities of the financial manager, in addition to ongoing
involvement in financial analysis and planning, are making Operating/tactical
decisions and making Strategic decisions.
 , which related to working capital decisions,
including:
- Short-term investment decisions (related to current insets).
- Short-term financing decisions (related to current liabilities).
 , which include:
- Long-term investment decisions (related to long term assets).
- Long-term financing decisions (related to long-term liabilities and
stockholders' equity).
From the above figures and discussions, financial activities/decisions can be

Investment decision Financing

 Short-term investment decisions  Short term financing decisions related to
related to current assets current liabilities
 Long-term investment decisions  Long term financing decisions related to long
related to long term assets term liabilities and stockholders' equity

Operating / Tactical decisions Strategic decisions

Working capital decisions: - Long-term investment decisions
- Short-term investment decisions related related to long term assets
to current assets - Long-term financing decisions
- Short-term financing decisions related to related to long-term liabilities and
current liabilities stockholders' equity

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4- For what basic reasons is profit maximization inconsistent with wealth
maximization ?

(1) The timing of earnings per share.

(2) Earnings which don’t represent cash flows available to stockholders.
(3) A failure to consider risk.

5- What is risk ? Why must risk as well as return be considered by the

financial manager who is evaluating a decision alternative or action?
Risk is the chance that actual outcomes may differ from expected outcomes.
Financial managers must consider both risk and return because of their
inverse effect on the share price of the firm. As increased risk may decrease
the share price, while increased return may increase the share price.

6- What is the goal of the firm and therefore of all managers and
employees ? Discuss how one measures achievement of this goal.
The goal of the firm, and therefore all managers, is to maximize shareholder wealth.
This goal is measured by share price; an increasing price per share of common
stock relative to the stock market as a whole indicates achievement of this goal.

7- Compare between "profit maximization" and "stock holder wealth

maximization" as a goal of the firm.
Profit Maximization Shareholders Wealth Maximization
Profit is based upon accrual Financial decision making based on cash
accounting principles. flows principal.
Profit measurement depends on Measurement depends upon present value
accounting policies and techniques of future cash flows.
adopted by company.
Conservatism/Carefulness. Realism (timing and risk of cash flows are
explicitly considered).

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1- The Egyptian financial system.

 The first sector is the banking financial sector which includes all
banks performing banking activities operating in the Egyptian
market,
 The second sector is the non-banking financial sector, which includes
all non-banking financial institutions performing non-banking
financial activities in the Egyptian market such as capital market,
insurance, mortgage financing, financial leasing, factoring, pension
funds, microfinance activities and securitization … activities.
In other words, the formal financial system in Egypt is comprised mainly of
Banking and Non-Banking Financial sectors, a brief review about each
sector will be presented in the following section.

A bank is a financial intermediary that offers loans, accepts deposits, and

offers other payment services. Nowadays banks also offer a wide range of
additional services.
In other words, u bank is a financial intermediary that accepts deposits and
channels those deposits into lending activities, either directly or through
capital markets. A bank connects customers with capital deficits (deficit
economic sectors) to customers with capital surpluses (surplus economic
sectors).
Banking financial sector in Egypt is governed and controlled by the Central
Bank of Egypt (CBE). Banks currently operate under the supervision of the
(CBE) and are governed by the Law of The Central Bank (Law No.88 of 2003,
amended by Law No. 162 of the Year 2004 and Law No. 93 of the Year 2005).
The Banking Law mandates the CBE to work on realizing price stability and
banking system soundness within the context of the general economic
policy of the State.

The Egyptian non-banking financial sector is governed and controlled by

the Egyptian Financial Supervisory Authority (EFSA). a public Authority,
having a legal status, established in accordance to law 10 of the year 2009,
EFSA supervises & regulates all non-banking financial markets and
instruments, including capital markets, futures exchanges, insurance
activities, mortgage finance, financial leasing, factoring, securitization and
microfinance.

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Laws enforced by the EFSA include Law on Insurance Supervision and
Control as promulgated by Law No. l0 of the year 1981, Capital Markets Law
No. 95/I992, Central Securities Depository and Registry Law No. 93 of 2000,
Law on Real Estate Finance promulgated by Law No. 148 of the year 2001;
their Executive Regulations and related decisions in addition to
Microfinance Law no. 141 of 2014. LFSA is also the administrative entity
that enforces the provisions of Financial Leasing l aw no. 95 of 1995.
EFSA is keen on the integrity and stability of non-banking financial
markets, and as it is interested in developing these markets and striking
balance among its dealers, and as it is concerned with issuing Laws that
grant market’s efficiency and transparency, HI SA has issued legislations
Encyclopedia and regulatory decisions related to non-banking financial
laws which regulate the work of the Authority and entities under its
supervision pursuant to law No. 10 of 2009.

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2- The role of the financial markets and financial institutions in the flow
of funds process.

Firms that they have financial need (financial requirements) from external
sources can get them in three ways:
1. Financial institutions
2. Financial markets
3. Private placements

 Financial institutions are intermediaries that channel the savings of

economic sectors (families/individuals, businesses, and governments)
into loans or investments and providing other financial services.
 Financial institutions facilitate smooth working of the financial
system by making investors and borrowers meet. They mobilize the
savings of investors either directly or indirectly via financial markets,
by making use of different financial instruments as well as in the
process using the services of numerous financial services providers.
 The key suppliers and demanders of funds are /individuals sector,
businesses sector, and government sector. ,
In general, families /individuals are net suppliers of funds, while
businesses and governments are net demanders of funds.

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  Financial markets can be defined as forums in which suppliers of
funds and demanders of loanable funds can transact business
directly.
 The products which are traded in a financial market are financial
assets, securities or other type of financial instruments. There is a
wide range of securities in the markets since the needs of investors
and credit seekers are different. Equity shares, debentures, and bonds
are examples.
 Financial markets bring together providers of funds and companies
seeking to raise capital.
 Capital rising can be done through:
- A private placement: A direct offering involves the sale of a new
security (stocks or bonds) directly to a local or foreign investor
or a local or foreign group of investors.
- A Public offering: involves the sale of a new security (stocks or
bonds) to general public (not exclusive offering). Most firms,
however, raise money through a public offering of securities.

3- The common classification of financial markets.

There are several classifications of financial markets. The most, known
classifications which are money market & capital market classifications
and primary market & secondary markets classifications.

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4- Compare between:

It's a market for financial, transactions in short term marketable securities. Such
marketable securities have maturity less than one year. The money market is
created by a financial relationship between suppliers and demanders of short-
term loan-able funds.
Most money market transactions are made in marketable securities which are
short-term debt instruments, such as U.S. Treasury bills, Egyptian Treasury bills,
commercial paper, and negotiable certificates of deposit ( as the case in USA)
issued by government, business, and financial institutions, respectively

It's a market for financial transactions in long-term securities. Such long* term
securities have maturity more than one year. The capital market is a market that
enables suppliers and demanders of long-term loan-able funds to make
transactions.
 The key capital market securities are bonds (long-term debt) and both
common and preferred stock (equity, or ownership).
 Bonds are long-term debt instruments used by businesses and government
to raise large sums of money, generally from a diverse group of lenders.
 Common stock is units of ownership interest or equity in a corporation.
 Preferred stock is a special form of ownership that has features of both a
bond and common stock.

- The Primary Market (issuing market) is a market for financial

transactions in new/initially issued securities (new issues), that is
securities issued for the first time whether they are short term
securities or long term securities, whether subsequently traded in the
money or capital market, securities are first issued through the
primary market.

- Secondary markets or trading markets are financial markets in which

pre-owned / pre- issued securities (not new issues) are traded such as
NYSE, American Stock Exchange, and Egyptian Stock Exchange.

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Question 2
Discuss in brief the efficient market hypotheses
 EMH states that the prices of securities fully and fairly reflect all relevant available information.

 If current share prices reflect all historical information This means it is not possible
Weak form to make abnormal returns using technical analysis or trading rules as the future
efficiency cannot be predicted in this way.
 If current share prices fully reflect all historical information and all relevant
Semi – publicly available information . Share prices react quickly and accurately to
Strong Form
incorporate any new and relevant publicly available information.
Efficiency  Abnormal returns cannot be made in a semi-strong form efficient
 Share prices reflect all relevant information including that which is privately held. No
one can make abnormal returns from share dealing even investors who act on insider
Strong Form information.
Market
Efficiency  Capital markets do not meet all the criteria for strong form efficiency since
some investors do make abnormal returns through insider dealing Capital
markets are deemed inefficient at this level of definition.

10 Dr. Heba Wahba

(1) "The capital asset pricing model (CAPM) is the basic theory that links
risk and return for all assets". Explain.
 The capital asset pricing model (CAPM) is the basic theory that links
risk and return for all assets.
 The CAPM quantifies the relationship between risk and return. It
measures how much additional return an investor should expect from
taking a little extra risk.
 The beta coefficient (B) is a relative measure of non-diversifiable risk.
It's an index of the degree of movement of an asset’s return in response
to a change in the market return.
 An asset’s historical returns are used in finding the asset’s beta
coefficient.
 The beta coefficient for the entire market equals 1.0. All other betas are
viewed in relation to this value.
 The market return is the return on the market portfolio of all traded
securities.

(2) "The security market line (SML) is not stable over time, and as a result
of shifting in SML, the required rate of return will be changed". Explain
- The Security Market Line (SML) is not stable over time, and as a result of
shifting in SML, the required rate of return will be changed.
- The main two major forces affecting the position and the slope of The
Security Market Line (SML) are:
 Inflationary expectations, and
 Risk aversion

 Changes in inflationary expectations result in parallel shifts in the

security market line (SML), in direct response to the magnitude
and direction of the change.
 The following figure shows this effect.

 Changes in risk aversion, and shifts in the Security Market Line

(SML), result from changing preferences of invertors.
 Increasing risk aversion results in a steepening in the slope of
SML. Decreasing risk aversion results in reducing the slope of SML.
 The following figure shows this effect

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3- You have been given the return data shown in the first table on three
assets – F, G, and H – over the period 2004 – 2007.

2017 16% 17% 14%

2018 17 16 15
2019 18 15 16
2020 19 14 17
Using these assets, you have isolated the three investment alternatives
shown in the following table :

1 100% of asset A
2 100% of asset C
3 40% of asset A and 60% of asset B
4 40% of asset A and 60% of asset C
3/1 Calculate the expected return over the 4-year period for each of the four
alternatives.
3/2 Calculate the standard deviation of returns over the 4-year period for
each of the four alternatives.
3/3 Use your findings in parts (A) and (B) to calculate the coefficient of
variation for each of the four alternatives.
3/4 On the basis of your findings, which of the four investment alternatives
do you recommend ? Why ?
Solution

Alternative 1: 100% Asset A

= = 15.5%
Alternative 2: 100% Asset B
= = 17.5%
Alternative 2: 40% Asset A  60% Asset B
Asset B  Asset A Portfolio
Year (wF  rF) (wG  rG) Return rp
2010 (14%  0.6  8.4%)  (17%  0.4  6.8%)  15.2%
2011 (15%  0.6  9%)  (16% 0.4  6.4%)  15.4%
2012 (16%  0.6  9.6%)  (15% 0.4  6%)  15.6%
2013 (17%  0.6  10.2%)  (14% 0.4  5.6%)  15.8%

. . . .
= = 15.5%

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 Alternative 3: 40% Asset A + 60% Asset C
Asset C Asset A Portfolio Return
Year (wF  rF)
+ (wH  rH) rp
2010 (16% 0.6  9.6%)  (14% 0.4  6.8%) 16.4%
2011 (17% 0.6  10.2%)  (15% 0.4  6.4%) 16.6%
2012 (18% 0.6  10.8%)  (16% 0.4  6.0%) 16.8%
2013 (19% 0.6  11.4%)  (17% 0.4  5.6%) 17.0%

. . .
= = 16.7%

ri r̅
 = √∑ni n

. . . .
=√ = 1.29

. . . .
=√ = 1.29

. . . . . . . .
=√ = 0.258

. . . . . . .
=√ = 0.258

C.V .
0.083
.
C.V .
0.073
.
C.V .
0.0166
.
C.V .
0.0154
.

Alternative 2 best as lower

C.V. Lower risk

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4) Stock (x) has a beta of 1.00, stock (Y) has a beta of 1.40, and stock (Z) has a
beta of -0.50.
4/1 Rank these stocks from the least risky to the riskiest.
4/2 If the return on the market portfolio increased by 12%, what change
would you expect in the return for each of the stocks ?
4/3 If the return on the market portfolio decreased by 5%, what change
would you expect in the return for each of the stocks ?
4/4 If you felt that the stock market was just ready to experience a
significant increase, which stock would you probably adds to your
portfolio ? Why ?
Solution
a.
Stock Beta
Most risky Y 1.40
X 1
Least risky Z – 0.5

b. and c.
Increase in Expected Impact Decrease in Impact on
Asset Beta Market Return on Asset Return Market Return Asset Return
Y 1 0.12 0.12 – 0.05 – 0.05
X 1.40 0.12 0.168 – 0.05 – 0.07
Z – 0.5 0.12 – 0.06 – 0.05 0.025

d. In a declining market, an investor would choose the defensive stock,

Stock Z. While the market declines, the return on Z increases.
e. In a rising market, an investor would choose Stock Y, the aggressive
stock. As the market rises one point, Stock Y rises 1.40 points.

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 5- Metal Manufacturing has isolated four alternatives for meeting its need
for increased production capacity. The data gathered relative to each of
these alternatives is summarized in the following table.
Alternative Expected Return Standard deviation of return
A 22% 7.0%
B 22 9.5
C 19 6.0
D 16 5.5
A. Calculate the coefficient of variation for each alternative.
B. If the firm wishes to minimize risk, which alternative do you recommend? Why?

Solution
7%
a. A CVA   0.3500
20%
9.5%
B CVB   0.4318
22%
6%
C
CVC   0.3158
19%
5.5%
D
CVD   0.3438
16%
b. Asset C has the lowest coefficient of variation and is the least risky
relative to the other choices.

6-
A)
K 500000 50% 14%
L 200000 20% 17%
M 300000 30% 10%

expected return of portfolio= 0.5x14%+0.2x17%+0.3x10%=

b)beta= 1.6x0.5+1.5x0.20-0.6x0.3=
c)
K 500000 50%
L 100000 10%
M 400000 40%
expected return of portfolio= 0.5x14%+0.1x17%+0.4x10%=
beta= 1.6x0.5+1.5x0.10-0.6x0.4=

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d-
Q7
R=14+1.8(17%-14%)=
Market risk premium=(17%-14%)=
Asset security risk premium= 1.8(17%-14%)=
b-Rf=11% Rm=14%
Asset security risk premium= 1.8(14%-11%)=
c-Rm=15%
Asset security risk premium= 1.8(15%-14%)=
Q8
a.
Project rj  RF  [bj(rm  RF)]
1 rj  12% [1.6(16%  12%)]  [1.6(16%  12%)]
2 rj  12% [0.8(16%  12%  2=[0.8(16%  12%
3 rj  12% [1.9(16%  12%  [1.9(16%  12%
4 rj  12% [00(16%  12%  4=[00(16%  12%
5 rj  12% [-0.7(16%  12%  5=[-0.7(16%  12%

Project 1 is 160% as responsive as the market.

Project 2 is 80% as responsive as the market.
Project 3 is 190% as responsive as the market.
Project 4 is unaffected by market movement.
Project 5 is 70% as responsive as the market, but moves in the opposite direction as the market.

12% [1.6(14%  12%)]

12% [0.8(14%  12%
12% [1.9(14%  12%
12% [00(14%  12%
12% [-0.7(14%  12%
. When investor risk aversion declines, investors require lower returns for any given risk level (beta).

Q9

For each asset, compute

The expected rate of return. (a)
The standard deviation of the expected return. (b)
The coefficient of variation of the return. (c)
Which asset should Champion select? (d)
Answer
(a)

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Expected Return = 15% 15%
2
(10% - 15%)^ × 0.30 = 7.5%
(15% - 15%)^2 × 0.40 = 0%
(20% - 15%)^2 × 0.30 = 7.5%
15%

Standard Deviation of A = 15%  3.87%

(5% - 15%)^2 × 0.40 = 40%

(15% - 15%)^2 × 0.20 = 0%
(25% - 15%)^2 × 0.40 = 40%
80%

Standard Deviation of B = 80%  8.94%

(c) CV(A) = 3.87/15 = 0.26 CV(B) = 8.94/15 = 0.60
(d) Asset A; for 15% rate of return and lesser risk.

Q10

Asset Annual return Probability Beta Proportion

‫مهم‬ X 10% 0.50 1.2 0.333
Y 8% 0.25 1.6 0.333
Z 16% 0.25 2.0 0.333

Solution
a)

(10 × 0.333) + (8% × 0.333) + (16% × 0.333) = 11% Propotion ‫آخذ‬

b)

Beta = (1.2 × 0.333) + (1.6 × 0.333) + (2 × 0.333) = 1.6

c. Has more risk than the market.

11-c

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12- A firm is considering building a portfolio containing two assets, L and M. asset L
will represent 40% of the dollar value of the portfolio, and asset M will account for
the other 60%. The expected returns over the next 6 years, 2017 – 2022, for each of
these assets, are shown in the following table.

2017 14% 20%

2018 15 18
2019 16 16
2020 17 14
2021 18 12
2022 19 10
a. Calculate the expected portfolio return, for each of the 6 years.
b. Calculate the expected value of portfolio returns, kp, over the 6-year period.
c. Calculate the standard deviation of expected portfolio returns, over the 6-year period.
d. How would you characterize the correlation of returns of the two assets L and M?
e. Discuss any benefits of diversification achieved through creation of the portfolio.

Solution
a. Expected portfolio return for each year: rp  (wLrL)  (wMrM)
Asset L Asset M Expected
Year +
(wLrL) (wMrM) Portfolio Return rp
2017 (14% x 0.40 = 5.6%) + (20% x 0.60 = 12.0%) = 17.6%
2018 (15% x 0.40 = 5.6%) + (18% x 0.60 = 10.8%) = 16.8%
2019 (16% x 0.40 = 6.4%) + (16% x 0.60 = 9.6%) = 16.0%
2020 (17% x 0.40 = 6.8%) + (14% x 0.60 = 8.4%) = 15.2%
2021 (17% x 0.40 = 6.8%) + (12% x 0.60 = 7.2%) = 14.0%
2022 (19% x 0.40 = 7.6%) + (10% x 0.60 = 6.0%) = 13.6%
n


j
wj  r j
1
b. Return Portfolio return: rp 
n
. . . . . .
rp = = 13

c. Standard deviation:

(ri  r )2
n
 rp  
i 1 ( n  1)

[ ]
rp = √ =

d. The assets are negatively correlated.

e. Combining these two negatively correlated assets reduces overall portfolio risk.

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13- You have been given the return data shown in the first table on three
assets – F, G, and H – over the period 2004 – 2007.

2017 16% 17% 14%

2018 17 16 15
2019 18 15 16
2020 19 14 17
Using these assets, you have isolated the three investment alternatives
shown in the following table :

1 100% of asset F
2 50% of asset F and 50% of asset G
3 50% of asset F and 50% of asset H
a. Calculate the expected return over the 4-year period for each of the three
alternatives.
b. Calculate the standard deviation of returns over the 4-year period for
each of the three alternatives.
c. Use your findings in parts (A) and (B) to calculate the coefficient of
variation for each of the three alternatives.
d. On the basis of your findings, which of the three investment alternatives
do you recommend? Why?

Solution

Alternative 1: 100% Asset F

16%  17%  18%  19%
rp   17.5%
4
Alternative 2: 50% Asset F  50% Asset G
Asset F + Asset G Portfolio
Year (wF x rF) (wG x rG) Return rp
2010 (16% x 0.50 = 8.0%) + (17% x 0.50 = 8.5%) = 16.5%
2011 (17% x 0.50 = 8.5%) + (16% x 0.50 = 8.0%) = 16.5%
2012 (18% x 0.50 = 9.0%) + (15% x 0.50 = 7.5%) = 16.5%
2013 (19% x 0.50 = 9.5%) + (14% x 0.50 = 7.0%) = 16.5%
16.5%  16.5%  16.5%  16.5%
rp   16.5%
4

19 Dr. Heba Wahba

 Alternative 3: 50% Asset F + 50% Asset H
Asset F Asset H Portfolio
+
Year (wF x rF) (wH x rH) Return rp
2010 (16% x 0.50 = 8.0%) + (14% x 0.50 = 7.0%) 15.0%
2011 (17% x 0.50 = 8.5%) + (15% x 0.50 = 7.5%) 16.0%
2012 (18% x 0.50 = 9.0%) + (16% x 0.50 = 8.0%) 17.0%
2013 (19% x 0.50 = 9.5%) + (17% x 0.50 = 8.5%) 18.0%

15.0%  16.0%  17.0%  18.0%

rp   16.5%
4

n
(ri  r )2
(1)  rp  
i 1 ( n  1)

[(16.0%  17.5%)2  (17.0%  17.5%)2  (18.0%  17.5%)2  (19.0%  17.5%)2 ]

F 
4 1
[(1.5%)2  (0.5%)2  (0.5%)2  (1.5%)2 ]
F 
3
(0.000225  0.000025  0.000025  0.000225)
F 
3
0.0005
F   .000167  0.01291  1.291%
3

[(16.5%  16.5%)2  (16.5%  16.5%)2  (16.5%  16.5%)2  (16.5%  16.5%)2 ]

 FG 
4 1
[(0)2  (0)2  (0)2  (0)2 ]
 FG 
3
 FG  0

20 Dr. Heba Wahba

 [(15.0%  16.5%)2  (16.0%  16.5%)2  (17.0%  16.5%)2  (18.0%  16.5%)2 ]
 FH 
4 1
[(1.5%)2  (0.5%)2  (0.5%)2  (1.5%)2 ]
 FH 
3
[(0.000225  0.000025  0.000025  0.000225)]
 FH 
3
0.0005
 FH   0.000167  0.012910  1.291%
3

CV   r  r
1.291%
CVF   0.0738
17.5%
0
CVFG  0
16.5%
1.291%
CVFH   0.0782
16.5%

rp: Expected Value

of Portfolio rp CVp
Alternative 1 (F) 17.5% 1.291% 0.0738
Alternative 2 (FG) 16.5% 0 0.0
Alternative 3 (FH) 16.5% 1.291% 0.0782
Since the assets have different expected returns, the coefficient of variation
should be used to determine the best portfolio. Alternative 3, with positively
correlated assets, has the highest coefficient of variation and therefore is the
riskiest. Alternative 2 is the best choice; it is perfectly negatively correlated
and therefore has the lowest coefficient of variation.

21 Dr. Heba Wahba

14- Stock (A) has a beta of 0.60, stock (B) has a beta of 1.50, and stock (C) has
a beta of -0.30.
B. Rank these stocks from the riskiest to the least risky.
C. If the return on the market portfolio increased by 12%, what change
would you expect in the return for each of the stocks ?
D. If the return on the market portfolio decreased by 5%, what change
would you expect in the return for each of the stocks ?
E. If you felt that the stock market was just ready to experience a significant
decline, which stock would you probably add to your portfolio? Why ?
F. If you anticipated a major stock market rally, which stock would you add
to your portfolio ? Why ?
Solution

a.
Stock Beta
Most risky B 1.50
A 0.60
Least risky C – 0.30
b. and c.

A 0.6 0.12 0.072 – 0.05 – 0.03

B 1.50 0.12 0.18 – 0.05 – 0.075
C – 0.30 0.12 – 0.036 – 0.05 0.015
d. In a declining market, an investor would choose the defensive stock,
Stock C. While the market declines, the return on C increases.
e. In a rising market, an investor would choose Stock B, the aggressive
stock. As the market rises one point, Stock B rises 1.50 points.

22 Dr. Heba Wahba

15- Fatma invested EGP 200,000 to set up the following portfolio one year ago:

A EGP50,000 0.90 EGP4200 EGP50,000

B 80.000 0.95 3.800 82.000
C 65.000 1.55 - 80.000
D 40.000 1.30 800 43.000
a. Calculate the portfolio beta on the basis of the original cost figures.
b. Calculate the percentage return of each asset in the portfolio for the year.
c. Calculate the percentage return of the portfolio on the basis of original
cost, using income and gains during the year.
d. At the time Jamie made his investments, investors were estimating that
the market return for the coming year would be 10%. The estimate of the
risk-free rate of return averaged 4% for the coming year. Calculate an
expected rate of return for each stock on the basis of its beta and the
expectations of market and risk – free returns.
e. On the basis of the actual results, explain how each stock in the portfolio
performed relative to those CAPM – generated expectations of
performance. What factors could explain these differences ?

Solution
a. bp = (0.90)(0.212) + (0.95)(0.34) + (1.55)(0.28) + (1.3)(0.17) = 1.167

b. rA = = = 8.4%

rB = = = 7.25%

rC = = = 23%

rD = = = 9. 5%

c. rP = = = 10.98%

23 Dr. Heba Wahba

d. rA = 4% + [0.90 x (10% – 4%)] = 9.4%
rB = 4% + [0.95 x (10% – 4%)] = 9.7%
rC = 4% + [1.55 x (10% – 4%)] = 13.3%
rD = 4% + [1.30 x (10% – 4%)] = 11.8%
e. Of the four investments, only C had actual returns that exceeded the
CAPM expected return. The underperformance could be due to any
unsystematic factor that would have caused the firm not do as well as
expected. Another possibility is that the firm’s characteristics may have
changed such that the beta at the time of the purchase overstated the
true value of beta that existed during that year. A third explanation is
that beta, as a single measure, may not capture all of the systematic
factors that cause the expected return. In other words, there is error in
the beta estimate.

1) "The value of any asset is the present value of all future cash flows it is
expected to provide over the relevant time period". In the light of this
sentence explain the basic valuation model and indicate how it can be
applied to calculate the value of bond.

Solution
 The value of any asset is the present value of all future cash flows it is
expected to provide over the relevant time period.
 The value of any asset at time zero, V0, can be expressed as
CF1 CF2 CFn
V0  1
 2
 ... 
(1  r ) (1  r ) (1  r ) n
2) Sara is considering investing in either of two outstanding bonds. The both
bonds have 1,000 par values and 14% coupon interest rates and pay annual
interest. The both bonds have exactly 4 years to maturity.
2/1 Use this information to calculate:
A) The value, the current yield and the yield to maturity of each bond
assuming that the required rate of return 12%.
B) The value, the current yield and the yield to maturity of each bond
assuming that the required rate of return 13%.
C) The value, the current yield and the yield to maturity of each bond
assuming that the required rate of return 14%.
2/2 From your findings in parts (a), (b) and (c), discuss the relationship
between the bond value and changing required returns.

Solution
24 Dr. Heba Wahba
2/1
a) B0 = 140 x 3.0373 + 1000 x 0.6355 = 1061
Yield to maturity = 12%
Current yield = = 13.19%
b) Bo = 140 x 2.9745 + 1000 x 0.6133 = 1029
Yield to maturity = 13%
Current yield = x 100 = 13.6%
c) Bo = 1000
Yield to maturity
Current yield = x 100 = 14%

2/2
There is a negative relationship between bond values and required returns;
indicating that the higher required rate of return the lower the bond's
value, the opposite is true. The following figure shows the relationship
between bond values and required returns.

3) Discuss the relationship between the bond value and time to maturity.
The shorter the amount of time until a bond’s maturity, the less responsive
is its market value to a given change in the required return.
Short maturities have less interest rate risk than long maturities when
other features are the same.

4) Discuss the main differences between debt and equity capital.

NO YES
Senior to Equity Subordinate to Debt
Stated None
Interest
No Deduction
Deduction

5) Define the following terms :

25 Dr. Heba Wahba

- is the rate of return that investors earn if they buy a bond
at a specific price and hold it until maturity. (Assumes
that the issuer makes all scheduled interest and principal
payments as promised)
- The yield to maturity on a bond with a current price equal
to its par value will always equal the coupon interest rate.
- When the bond value differs from par, the yield to
maturity will differ from the coupon interest rate.
Is a measure of bond’s cash return for a year; calculated by
dividing the bond’s annual interest payment by its market
price

26 Dr. Heba Wahba

 is the rate of return that investors earn if they buy a bond at
a specific price and hold it until call
is the rate of return that investors earn if they buy a bond at
a specific price and hold it until sold

2- A firm's most recent common stock dividend was $ 2.40 per share,
because of its maturity as well as its stable sales and earnings, the firm's
management feels that dividends will remain at the current level for the
foreseeable future.
a. If the required return is 12%, what will be the value of Scotto's common stock?
b. If the firm's risk as perceived by market participants suddenly increases, causing
the required return to rise to 20%, what will be the common stock value?
c. Judging on the basis of your findings in parts (a) and (b), what impact
does risk have on value ? Explain.

Solution
a. P0 $2.40  0.12 $20
b. P0 $2.40  0.20 $12
c. As perceived risk increases, the required rate of return also increases,
causing the stock price to fall

3- A firm wishes to estimate the value of its outstanding preferred stock.

The preferred issue has an $ 80 par value and pays an annual dividend of $
6.40 per share. Similar – risk preferred stocks are currently earning a 9.3%
annual rate of return.
a. What is the market value of the outstanding preferred stock ?
b. If an investor purchases the preferred stock at the value calculated in part a
, how much does she gain or lose per share if she sells the stock when the
required return on similar – risk preferred has risen to 10.5% ? Explain.

Solution
a. PS0  $6.40  0.093
PS0  $68.82
b. PS0  $6.40  0.105
PS0  $60.95

27 Dr. Heba Wahba

The investor would lose $7.87 per share ($68.82  $60.95) because, as the
required rate of return on preferred stock issues increases above the 9.3%
return she receives, the value of her stock declines.

28 Dr. Heba Wahba