Learning Activity 5.

2 solution

Recall:
ERP = A + (1 B;
A + (1 AB]
2 2 2 2
P B
covAB i(RA ERA)(RB ERB)]
Correlation coefficient, rAB: = covAB/ A B

25% in C
ERP = 0.25 x 25% + 0.75 x 20% = 21.25%
P 0.252 x 0.152 + 0.752 x 0.12 + 2 x 0.25 x 0.75 x 0.24 x 0.15 x 0.1] = 0.092 or 9.2%

50% in C
ERP = 0.5 x 25% + 0.5 x 20% = 22.5%
P
2
x 0.152 + 0.52 x 0.12 + 2 x 0.5 x 0.5 x 0.24 x 0.15 x 0.1] = 0.0996 or 10.0%

75% in C
ERP = 0.75 x 25% + 0.25 x 20% = 23.75%
P
2
x 0.152 + 0.252 x 0.12 + 2 x 0.75 x 0.25 x 0.24 x 0.15 x 0.1] = 0.12096 or 12.1%

M&A
ERP = 0.5 x 11% + 0.5 x 20% = 15.5%
P
2
x 0.172 + 0.52 x 0.292] = 0.168 or 16.8%

A&L
ERP = 0.5 x 20% + 0.5 x 14% = 17%
P
2
x 0.292 + 0.52 x 0.212 + 2 x 0.5 x 0.5 x 0.4 x 0.29 x 0.21] = 0.21 or 21.0%

M&L
ERP = 0.5 x 11% + 0.5 x 14% = 12.5%
P
2
x 0.172 + 0.52 x 0.212 + 2 x 0.5 x 0.5 x 0.62 x 0.17 x 0.21] = 0.1712 or 17.1%

Clearly M&A is better than M&L since it has higher return for lower risk. However, decision
as to which is the better between M&A and A&L is not as straightforward, since although the
latter has a higher return, it also has increased risk. The company and shareholders attitude to
risk is therefore important here and also their utility function needs to be known.

Choosing two out of three possible investments based on historical information is risky. A
combination of all three investments may be better but no information is given to calculate
this. The third, unchosen investment could perform well and this would mean the company
has missed out.