RISK AND RETURN

T6.2
Ms Lindiwe Mkhize has just been promoted. Lindiwe intends to invest a proportion of her
money in a portfolio of shares. Her colleague, Mr John Smith, recommends investing in two
companies – Aldworth Co and Badenhorst Co. He says that he has been very happy with
the performance of his portfolio, 30% of which consisted of Aldworth Co shares and 70% of
Badenhorst Co shares. The beta coefficient of Aldworth Co and Badenhorst Co are -0.07
and 0.36 respectively. The following information is available about the market and the two
companies:

Market Aldworth Badenhorst

return Co Co
Year rM rA rB
2002 22% 10% 37%
2003 18% 16% 24%
2004 8% 16% –5%
2005 14% 17% 24%
2006 10% 18% 20%

In 2010 the expected return on the market is 25%, and the risk-free rate is 12%. The
expected return on Aldworth’s shares is 8% and the expected return on Badenhorst’s shares
is 30%.

COVA, M COVB, M COVA, B

–13,7 75,5 –24,5

REQUIRED:

a) Calculate the average return and the standard deviation of returns for Aldworth Co and
Badenhorst Co for the period 2005–2009.Show the relevant formulae.
b) Interpret the beta (systematic risk) of Aldworth Co and Badenhorst Co’s shares.
c) Calculate the average return and the total risk of Mr Smith’s portfolio for the years 2005-
2009. Show the relevant formulae.
d) Advise Mr Smith whether he should continue to hold shares in each of the two
companies in 2010. Motivate your answer.
e) Assume that Mr Smith will adjust his portfolio so that next year (2010) the portfolio will be
invested 50% in Aldworth Co, 20% in Badenhorst Co, and 30% in risk-free securities.
What is the expected return and systematic risk of his portfolio during 2010? Show the
relevant formula.
T6.3 (BFB LAO 2013 Q5.1)

PART A
YEAR   2010 2011 2012 2013 2014 2015
 
ACTUAL Expected
R R R R
Amanzi Company N/A N/A
2.30 2.50 2.75 3.15
Holiday Resorts 12% 11% 9.80% 10% 10.20% 11.50%
Office Parks 9% 9.30% 9.50% See note 1
11.50
Retail Buildings 11.00% 13.00% 10% 12.30% 13%
%

Note 1:
Office parks 2013 2014 2015 2013 2014 2015
State of the Probability of occurrence
Expected returns
economy (%)
Recession 10.00% 10.30% 9.80% 30% 25% 27%
Normal 10.50% 10.60% 10.20% 50% 45% 40%
Strong growth 12.00% 11.50% 10.50% 20% 30% 33%

REQUIRED
a) Calculate the one year holding period return for Amanzi Company for 2012. (2)
b) Calculate the average historic return on Holiday Resorts from 2010 to 2012 using the
arithmetic mean method. (2)
c) Calculate the expected return for Office Parks for 2014 taking into account the state
of the economy. (4)
d) Assuming that the average historical return of Retail Buildings from 2011 to 2012 is
11.23%, calculate the variance and standard deviation of Retail Buildings for the same
period. (2)

H4.1: Big 4 Accounting Bursary1

Based on Ayanda’s excellent results at the end of her first year of university Big4
Accounting, decides to sponsor her for the remainder of her university studies. They would
like to invest enough money in an investment today which must make the following
payments for a period of 3 years.

Year Book Residence and Tuition fees Total

1
 allowance Dining hall fees

2016 R4 000 R6 000 R10 000 ?

2017 R5 000 R8 000 R12 000 ?

2018 R6 000 R10 000 R14 000 ?

REQUIRED:

Assuming an interest rate of 12% per annum, calculate the PV of the cash flows. (4)

H4.2: Renovations

You are planning on doing renovations to your home when your current savings of
R40 000 reaches R80 000.

REQUIRED:

a) If you plan to do your renovations at the end of five years from now, calculate the annual
rate of interest which will you have to earn on your savings account? (2)

If you can earn 7% per year compounded monthly on your savings account, determine how
long it will take you before you have adequate funds to complete all your renovations?

H4.6: Tertiary funding2

Your parents want to invest for your sibling, who is currently in Grade 7, in order to
save for her tertiary studies. You have informed them that it will cost a maximum of
R100 000 to fund 3 years-worth of tertiary education when she has completed Grade
12, and that they can invest in unit trusts where they can make monthly deposits. Your
banker also informed you that they can earn 6.5% return, compounded monthly.
Your banker also informs your parents that there is an option of a lumpsum investment
of R50 000 for 5 years at an interest rate of 10% per annum compounded annually

REQUIRED
i. Identify the five variables of time value of money for each option. (2)
ii. How much must your parents invest each month towards the unit trusts for the
next 5 years in order to have the required tertiary funding? (3)
iii. If they take up the lump sum option how much funding would they have at the
end of the 5 year period? (3)

2
Supplementary exam – June 2012 – Question 4
Using your answer from part 2 and 3 above, which option would you suggest your parent
select in order to have the required funding and why?

H4.8: Amortisation

A customer asks you to calculate his monthly instalments if he borrows R750 000 at 14% per
annum, compounded monthly.

Required:
a) If his repayment period is 48 months, what should his monthly instalment be?
b) If he wants to pay in 36 months, what should his monthly instalment be?
i. What is the total capital repayment for the first 12 months
ii. Present the amortisation table for the 3 year period in years.
PART B
Investment Investment Weight Expected Variance
return
Mining Company R750 000 ? 15% 8%
Department Stores R800 000 ? 8% 25%
Jewellery Company R1 500 000 ? 13% 27%

REQUIRED
a) Calculate the weight of each investment in the portfolio if Mr Biggs invests in all 3 shares.
(2)
b) Calculate the expected return of the portfolio if all 3 investments were included. (2)
c) If Mr Biggs decide to only include the Mining Company and Department Stores in his
portfolio at weighting of 60% and 40% respectively, calculate the variance and
standard deviation if the covariance is 80. (4)
d) Is Mr Biggs portfolio diversified? Give reasons for your answer. (2)

T4.2 Mr Dlamini

Mr Dlamini wishes to choose the better of two equally costly cash flow streams, annuity X
and Annuity Y. X is an annuity due with a cash inflow of R9 000 for a period of 6 years. Y is
an ordinary annuity with a cash inflow of R10 000 for a period of 6 years. Assume that Mr
Dlamini can earn 15% on all his investments.

REQUIRED:

a) Determine the future value at the end of year 6 for both annuity X and annuity Y. (4)
b) Calculate which annuity is a better choice and state the reasons why. (2)