Tutorial 6 (Answers)

Corporate Finance – BA303

1. The ordinary shares of Firm A have a Beta of 1.23. The risk-free rate of interest is 5 per
cent, and the risk premium achieved on the market index over the past 20 years has
averaged 11.5 per cent p.a. What is the future expected return on A’s shares? If you
believe that overall market returns will fall to 8 per cent in future years, how does your
answer change?
Answer :
E(R) = 0.05 + 1.23(0.115) = 0.19145 = 19.145%
With more pessimistic expectations about market returns, this drops to :
E(R) = 0.05 + 1.23(0.08 – 0.05) = 0.087 = 8.7%

2. Supply the missing links in the table:

Answer :
(i) Rf = 8%
(ii) Beta = 1.71
(iii)ERj = 8.5%
(iv) ERm = 19.3%

3. Which of the following shares are over-valued?

The risk-free rate is 5 per cent, and the return on the market index is 10 per cent.

1
Answer :

4. Locate the Security Market Line (SML) given the following information: Rf = 8%,
E(Rm) = 12%.
Answer:
E(Ri)
12%
8%

βm β

5. The market portfolio has yielded 12% on average over past years. It is expected to offer a
risk premium in future years of 7%. The standard deviation of its return is 8%. The risk-free
rate is 5%.
(a) What is the expected return from the market portfolio ?
(b) Draw a diagramme to show the location of the capital market line (CML).
(c) What is the expected return on a portfolio comprising 50% invested in the
market portfolio and 50% invested in the risk-free asset ?
(d) What is the risk of the portfolio in (c) ?
(e) What is the market trade-off between portfolio risk and return suggested by
these figures ?
Answers:
a) 12%
b) Refer to lectures slides/text book. I will also draw on the board for you during the
tutorial.
c) E(Rp) = 0.5(12%) + 0.5(5%) = 8.5%
d) σp = [(0.5)2(0)2 + (0.5)2(0.08)2]0.5 = 0.04 = 4%
e) If you invest 100% in the market portfolio, you enjoy a return of 12% with a portfolio
risk of 8%. However, if you only invest 50% in the market portfolio with the balance
invested in government bonds, you will only enjoy a return of 8.5% with a portfolio risk
of only 4%. The trade-off here is that if you want to enjoy a higher return through
investment in the market portfolio, you have to undertake higher risk by investing in a

2
higher percentage of the market portfolio and vice versa. There is no free lunch. The
relationship between risk and return is positive. An increase in 4% risk provides a return
of 3.5% to the investor. Therefore, for every 1% of the risk the investor undertakes,
he/she must be compensated with 0.875% of return.