FM201 - Financial Institutions & Markets

Tutorial 5 Solutions

Chapter 6
1. Outline two general strategies or approaches that can be taken to investing in the share
market.
 There are two general approaches that an investor might take when investing in shares:
active or passive.
 An active investor chooses investments and a portfolio structure based on share analysis,
new information and the balance of risk and return. The investor will actively search for
new opportunities, analyze the cash flows of companies, assess the financial ratios of
potential investments and consider the products and management of companies that
might be potential investments.
 A passive investor, by contrast, does not actively analyze companies and search for
individual investment opportunities. Rather, the passive investor allocates his or her
portfolio in precisely the same proportions as an index (such as the ASX200). If, for
example, Telstra makes up 5% of the index, then Telstra will make up 5% of the investor’s
portfolio. The performance of the portfolio will track the index. No attempt is made to
improve the performance by any of the active management or investment selection
strategies.

2. Ms. Brown has an investment portfolio comprising Fijian shares. At a meeting with her
investment advisor she requests explanations of the following:
a. The definition of systematic risk and unsystematic risk, and an explanation of factors that
are responsible for the two types of risk.
 In its basic form, risk comprises components of probability, variance, volatility and
uncertainty. Probability is a statistical estimate of a variance in an expected outcome.
Volatility relates to the degrees of change that historically have occurred in outcomes
over time and uncertainty is the possibility that an unexpected outcome might occur.
 Systematic risk is exposures of a share portfolio to changes in the environment that
have the effect of impacting the majority of shares listed on a stock exchange. For
example, changes in interest rates, exchange rates or economic activity.
 FM201 - Financial Institutions & Markets
Tutorial 5 Solutions

 Unsystematic risk relates to exposures that specifically affect the share price of a
particular corporation. For example, loss of key personnel or systems, or a downgrade
of performance forecasts.
b. Why should an investor not expect to be rewarded for the unsystematic risk element in a
share portfolio?
 An investor is able to minimize unsystematic risk by holding a diversified investment
portfolio; for example, a portfolio of shares, property and fixed interest investments.
Within the share portfolio the investor can hold shares in a number of companies, a
range of industry sectors, and across different countries.
 Therefore, as investors are able to hold diversified investment portfolios, prices will
not incorporate a significant risk component for unsystematic risk.

3. An investor holds the following shares in an investment portfolio:

JB Hi Fi $6500 beta 1.20

Telstra $8600 beta 0.95

ANZ Bank $7900 beta 1.05

a. What does each beta coefficient imply about the volatility of each company’s shares
relative to the overall market?
 Beta is the amount of systematic risk that is present in a particular share relative to
the share market as a whole.
 The market has a beta of 1.0.
 In the above portfolio, JB Hi Fi and ANZ have betas greater than 1.00. As such, they
are more volatile than the market. When the S&P/ASX 200 increases (decreases) by
10 per cent, JB Hi Fi’s price will increase (decrease) by 12 per cent or 1.20 times as
much. Following the same market movement, ANZ shares will increase (decrease) in
price by 1.05 times as much or, in this case, by 10.50 per cent. Because Telstra has a
beta of 0.95, it will move less than proportionally with the market.
 FM201 - Financial Institutions & Markets
Tutorial 5 Solutions

b. Calculate the portfolio’s beta?

The weighted average beta of the portfolio is:
Stock Amount Weight Beta Weighted Beta
JB Hi Fi $6,500 28.3% 1.20 0.34
Telstra $8,600 37.4% 0.95 0.36
ANZ Bank $7,900 34.3% 1.05 0.36
$23,000 1.06

c. If the investor added to the portfolio with the purchase of $5000 worth of shares in Myer
(beta 1.60), what impact would that purchase have on the risk structure of the portfolio?
Calculate the new weighted average beta?

If the investment in Myer is added to the portfolio the weighted average beta
of the portfolio becomes:
Stock Amount Weight Beta Weighted Beta
Meyer $5,000 17.86% 1.60 0.29
JB Hi Fi $6,500 23.21% 1.20 0.28
Telstra $8,600 30.71% 0.95 0.29
ANZ Bank $7,900 28.21% 1.05 0.30
$28,000 1.15

 By adding the risky investment in Myer, the investor has increased the volatility of the
portfolio. This is reflected in the increased systematic risk.
 That is, the average weighted beta is now quite a bit higher than the market beta.
4. Luke shares with you the following information regarding his investment portfolio:
 Investment in three shares: CFL, FTV & KFL.
 Total portfolio is worth $59,000.
 Investment in KFL is twice the size of CFL.
 28% of the portfolio is invested in CFL shares.
 Weighted Beta of CFL and KFL are 0.35 and 0.55 respectively.
 FTV’s share is 0.25 more risky than the market.
a. The total dollar value of each share in Luke’s portfolio.
b. Beta of CFL.
c. Beta of KFL.
d. Weighted beta of FTV.
e. The portfolio’s weighted beta.
 FM201 - Financial Institutions & Markets
Tutorial 5 Solutions

f. Luke adds to his current portfolio shares of RBG worth of $11,000. Recalculate the
portfolios new weighted beta and briefly explain the impact RBG share purchases has on
the risk structure of Luke’s portfolio? RBG shares has a beta of 1.5.
total portfolio = $59,000

w b w.b
CFL 28% 1.25 0.35
KFL (2*CFL) 56% 0.98 0.55
FTV 16% 1.25 0.20
100%

a. $ Values: CFL 28% $16,520

KFL 56% $33,040
FTV 16% $9,440
$59,000

b. CFL beta = 1.25

c. KFL beta = 0.98

d. FTV Weighted beta= 0.20

e. Portfolio WB = 0.35
0.55
0.20
1.10

f. total portfolio = $70,000

$ value w b w.b
CFL $16,520 23.6% 1.25 0.30
KFL $33,040 47.2% 0.98 0.46
FTV $9,440 13.5% 1.25 0.17
RBG $11,000 15.7% 1.50 0.24
$70,000 100% 1.16

Therefore, by adding RBG shares to the portfolio, the portfolio's

risk has increased.

5. Caltex Australia Limited pays a constant dividend of $0.60 cents per share. A fund manager is
considering purchasing the shares as part of an investment portfolio. The fund manager
requires a return of 15 per cent on the investment. Calculate the price that the fund’s
manager would be willing to pay for the shares.

 If dividend payments are expected to remain constant, such that D0 = D1 = D2 = …. Dn,

the share price can be calculated based on a perpetuity.

 The present value of a perpetuity is the cash flow divided by the relevant discount
rate: P0 = D0 / rs
 FM201 - Financial Institutions & Markets
Tutorial 5 Solutions

 Caltex is expected to pay a constant dividend of $0.60 cents per share, and the funds
manager’s required rate of return is 15%, therefore:

𝑃0 = 0.60/0.15
= $4.00

6. The last dividend paid to shareholders by Vicinity Centers was $0.10 per share. Assume
that the board of directors of the company plans to maintain a constant dividend growth
policy of 7.00 per cent. An investor, in evaluating an investment in the company, has
determined that she would require a 12 per cent rate of return from this type of
investment. If the current price of Vicinity shares in the stock market is $4.00, should the
investor purchase the shares? (Show your calculations.)

 Vicinity is planning to maintain constant dividend growth. Therefore, the next dividend
paid will be the last dividend multiplied by the growth rate:

𝑃0 = 𝐷0 (1 + 𝑔)/(𝑟𝑠 − 𝑔)
= 0.10 (1.07)/(0.12 − 0.07)
= $2.14

 At a current market price of $4.00 the investor should not consider buying the shares
based on this simple analysis. Rather, to justify a purchase at $4.00, the required rate
of return must be lower or the growth rate of the dividends must be higher.

7. AGL Energy Limited has declared a $0.33 cents per share dividend, payable in one month. At
the same time the company has decided to capitalize reserves through a one-for-three
bonus issue. The current share price at the close of business on the final cum-dividend date
is $16.15.
Calculate the theoretical price of the share after the bonus issue and the dividend payment
have occurred.
 FM201 - Financial Institutions & Markets
Tutorial 5 Solutions

cum-dividend share price $16.15 a

dividend paid 0.33 b
ex-dividend price $15.82 c = a-b
cum-bonus/ex-dividend price $15.82 c
market value of 3 cum-bonus shares $47.46 d=cx 3
market value of 4 ex-bonus shares $47.46 d
theoretical value of ex-dividend/ex-
$11.87 e = d/4
bonus share
8. Alumina Limited has a share price of $2.82. The company has made a renounceable rights
issue offer to shareholders. The offer is a three-for-ten pro-rata issue of ordinary shares at
$2.60 per share.
a. Explain the effect of the offer being renounceable.
 Rights issue—the issue of additional ordinary shares to existing shareholders on a pro-
rata basis relative to their existing shareholding.
 Renounceable—the right is listed on the stock exchange and the shareholder is
entitled to sell the right to a third party rather than accepting the offer.

b. What is the price of the right?

𝑁(𝑐𝑢𝑚 𝑟𝑖𝑔ℎ𝑡 𝑝𝑟𝑖𝑐𝑒 − 𝑠𝑢𝑏𝑠𝑐𝑟𝑖𝑝𝑡𝑖𝑜𝑛 𝑝𝑟𝑖𝑐𝑒)
𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑟𝑖𝑔ℎ𝑡 =
𝑁+1
where N is the number of shares required to obtain the rights issue share, and the
subscription price is the discounted price of the additional share. Therefore:
3.3333($2.82 − $2.60)
𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑟𝑖𝑔ℎ𝑡 =
4.3333
$0.7333
=
4.3333
= 16.92𝑐𝑒𝑛𝑡𝑠

c. Calculate the theoretical ex-rights share price.

cum-rights share price $2.82 a
Market value of 10 cum-rights shares $28.20 b = a x 10

plus :
new cash introduced through take-up
$7.80 c = 2.60 x 3
of 3 for 10 issue
gives :
market value of 13 ex-rights shares $36.00 d = b + c
therefore :
theoretical ex-rights share price $2.77 e = d/13