FIN 423: Securities Analysis and Portfolio Management Points: 30

YOU HAVE TO ANSWER EACH SECTION SEPARATELY

Student Name: Student ID#:

YOU HAVE TO ANSWER IN THE QUESTION PAPER

SECTION A: Descriptive

Answer any TWO of the following questions (2*5

points)

a. What is the efficient frontier? Why is it called efficient for portfolio investment?
b. What is investment risk? How does systematic risk differ from unsystematic risk?
c. Chapa Cola Company is in the maturity stage of its industry’s life cycle. As an investor, what are your
expectations from the company in terms of sales growth, financing sources, competition, and
distribution of profit?
d. What is the price earnings ratio? Which industries have traditionally found to command high price
earnings ratio and why?

SECTION B: Quantitative

Problem 1 (2 + 2 + 3 = 7 points)

You are contemplating investing Tk.750 thousand in the common stocks of shonali Ansh (S) and Chiro
Plastics (C) companies. You will invest Tk.262,500 in Sonali Ansh and the remainder in Chiro Plastics.
You have collected the following data for your analysis:

 Expected rate of return from Shonali Ansh (kS): 9%

 Standard deviation of return from Ansh (sdS): 4%
 Expected return from Chiro Plastics (kC): 13%
 Standard deviation od return from Chiro Plastics (sdC): 3
 Coefficient of correlation between the returns from the two stocks (rSC): 0.63.

a. What is your expected rate of return from the portfolio that you have contemplated with the two
stocks?
b. What is the standard deviation of the portfolio?
c. Which stock is more risky and why?

Problem 2 (8 points)

The stock of R. J. Enterprises (RJE) Ltd. Is currently trading at the “Feni Stock Exchange (FSE)” at Tk.50
per share. The stock paid a per share dividend of Tk.6.00, which is expected to grow at a constant rate
of 4 percent per year. The all-share market return at FSE is 11% and the risk free return is 7 percent.
The RJE stock has a beta coefficient of 0.40.

a. What value would you estimate for RJE stock?

b. What would be your investment strategy with respect to RJE stock?

Problem 3 (5 points)

You are in the process of calculating the value Rockwell Company’s common stock on 06-Dec-20. You
expect that the company will pay its first ever dividend in 2023. Based on the cash dividends paid by the
competitors in the industry, you estimate that Rockwell’s cash dividend will be Tk.8.00 per share. As the
industry that Rockwell is in, is in the maturity stage of the life cycle, you believe that the company’s
dividends will grow at a constant rate of 5% every year. The required return on Rockwell’s stock is 11
percent.

Calculate the value of Rockwell stock.

START YOUR ANSWERS FROM HERE

Section A
a) Answer:

The efficient frontier is the set of optimal portfolios that offer the highest expected return for
a defined level of risk or the lowest risk for a given level of expected return.

Portfolios that lie below the efficient frontier are attainable region but they do not provide
enough return for the level of risk. The efficient frontier graphically represents portfolios that
maximize returns for the risk assumed.

Returns are dependent on the investment combinations that make up the portfolio. The
standard deviation of a security is synonymous with risk. Ideally, an investor seeks to
populate the portfolio with securities offering exceptional returns but whose combined
standard deviation is lower than the standard deviations of the individual securities. The
main concept was the benefit of diversification resulting from the curvature of the efficient
frontier. The curvature is integral in revealing how diversification improves the portfolio's risk
reward profile. It also reveals that there is a diminishing marginal return to risk. The
relationship is not linear. In other words, adding more risk to a portfolio does not gain an
equal amount of return. Optimal portfolios that comprise the efficient frontier tend to have a
higher degree that’s how it is called efficient for portfolio investment.
b) Answer:

Investment risk can be defined as the probability or likelihood of occurrence of losses relative
to the expected return on any particular investment.

Systematic risk can be defined as a type of total risk that arises as a result of various external
factors such as political factors, economic factors, and sociological factors. Systematic risk is
non-diversifiable in nature. This means that this type of total risk cannot be controlled or
minimized or avoided by the management of an organization. A systematic risk has the
tendency to disrupt not just the whole of the market but an economy too. The major sources
of systematic risk are risks related to the market, purchasing power, and interest rate and the
common examples of such type of risk are inflation, price movements, fluctuation in interest
rates, rise in unemployment, etc.

On the other hand, unsystematic risk can be defined as a type of total risk that arises as a
result of various internal factors taking place within an organization. Unsystematic risks are
diversifiable in nature. This means that these types of risks can be controlled, minimized and
even avoided by the management of an organization. The major sources of such risks are risks
pertaining to finances, business, and insolvency and the common examples of the same are a
higher rate of operational costs, a rise in labor turnover, etc .

To sum up, although we cannot work with the systematic risk we have many things to do
with unsystematic risk because if we can manage it in a better way, then our business will be
more profitable with lower risk. By choosing negatively related investment alternatives we
can form an optimal portfolio but it is not an easy task for the financial manager. There is the
involvement of risk with every investment alternatives but we have to consider the
systematic portion and then work with controllable factors which we actually can improve.

Section B
Problem 1:

750 000
 Sonali = 262 500
Chiro = 750 000 – 262 500 = 487 500

a) What is your expected rate of return from the portfolio that you have contemplated with the
two stocks?

Expected rate of return Kp = Ws Ks + Wc Kc

= 35% * 9% + 65% * 13%

= 11.6 %

b) What is the standard deviation of the portfolio?

SD of portfolio = sqrt(.35^2 * .04^2 + .65^2 * .03^2 + 2 *.35 * .65 * .04 * .03 * 0.63 )

= 0.0303

= 3.033%

c) Which stock is more risky and why?

Stocks of shonali Ansh is more risky. Because it has higher Standard Deviation than the Stocks of
Chiro Plastics. The large the SD , Higher the risk.

CV(S) = SD/Kp = 0.04 / 0.116 = 0.345 (more risky)

CV(C) = SD/Kp = 0.03 / 0.116 = 0.258

Higher CV means Higher Risk.

Problem 2:

a) What value would you estimate for RJE stock?

Ks = Krf + (Km - Krf) * beta
 = 0.07 + (0.11 – 0.07) * 0.40
= 0.086 = 8.6 %
Po = D / (Ks - g)
= 6 / (0.086 – 0.04)
= 130.434

b) What would be your investment strategy with respect to RJE stock?

I will invest more on the market. Reason

 Beta<1 which means stock is less volatile compared to the market.

 Estimated value is higher than the current price.

Problem 3:

You are in the process of calculating the value Rockwell Company’s common stock on 06-Dec-20. You
expect that the company will pay its first ever dividend in 2023. Based on the cash dividends paid by the
competitors in the industry, you estimate that Rockwell’s cash dividend will be Tk.8.00 per share. As the
industry that Rockwell is in, is in the maturity stage of the life cycle, you believe that the company’s
dividends will grow at a constant rate of 5% every year. The required return on Rockwell’s stock is 11
percent.

PV of dividend = D(n)/(1+KS)^n

Year Dividend per PV factor PV of dividends

share
1 (2020) 8 0.9009 7.207
2 (2021) 8+(8*0.05)=8.4 0.8116 6.817
3 (2022) 8.82 0.7312 6.449
4 (2023) 9.261 0.6587 6.100

PV of non-constant dividends 26.573

P3 = D4/(kS – g )

= 9.261 / (0.11-0.05)
= 154.35

Po = 154.35/(1+0.11)^3

= 112.859

Po = 26.573 + 112.859 = 139.432 (Ans).