EDBAS 202 Corporate Financial Management

Portfolio Theory – Additional Problems

1. Shares in Whitchat plc can be purchased today for £1.20. The expected dividend in one year is
5p. This is expected to be followed by annual dividends of 6p and 7p respectively in the following
two years. The shares are expected to be sold for £2 in three years. What is the average annual
rate of return? What is the three-year holding-period return?

2. You are thinking about investing your money in the stock market. You have the following two
stocks in mind: stock A and stock B. You know that the economy can either go in recession or it
will boom. Being an optimistic investor, you believe the likelihood of observing an economic
boom is two times as high as observing an economic depression. You also know the following
about your two stocks:

State of the Probability RA RB

Economy

Boom 10% –2%

Recession 6% 40%

a) Calculate the expected return for stock A and stock B

b) Calculate the total risk (variance and standard deviation) for stock A and for stock B
c) Calculate the expected return on a portfolio consisting of equal proportions in both stocks.
d) Calculate the covariance between stock A and stock B.
e) Calculate the correlation coefficient between stock A and stock B.
f) Calculate the variance of the portfolio with equal proportions in both stocks using the portfolio
returns and expected portfolio returns from answer c.

3. An investor holds two equity shares X and Y in equal proportion with the following risk and return
characteristics:

Expected return of X= 24% Expected return of Y =19%,

Standard deviation of X =28% Standard deviation of Y = 23%

The returns of these securities have a positive correlation of 0.6. You are required to calculate the
portfolio return and risk. Further, suppose that the investor wants to reduce the portfolio risk to
15%. How much should the correlation coefficient be to bring the portfolio risk to the desired level?

Asanka Ranasinghe MBA (Colombo), BBA (Finance), ACMA, CGMA

EDBAS 202 Corporate Financial Management

4. The stock of Alpha Ltd. performs well relative to other stocks during recessionary periods. The
stock of Beta Ltd., on the other hand, does well during growth periods. Expected rate of return
of these stocks for the next year are estimated as follows:

a. Calculate the expected rate of return and standard deviation for the stock of Alpha Ltd. and
stock of Beta Ltd. separately.

b. Calculate the coefficient of variation for both stocks.

c. If you are an investor, which company you would select for the investment?

5. Kim Ltd, an all equity financed multinational is contemplating an expansion into an overseas
market. It is considering whether to invest directly in the country concerned by building a
greenfield site factory. The expected pay-off from the project would depend on the future state
of the economy of Sri Lanka, the host country, as shown below;

Kim’s existing activities are expected to generate an overall return of 30% with a standard deviation of
14%. The correlation coefficient of Kim ’s returns with that of the new project is –0.36. Kim’s returns
have a correlation coefficient of 0.8 with the return on the market portfolio, while the new project has
a correlation coefficient of –0.1 with the Korea’s market portfolio. The Beta coefficient for Kim Ltd. is
1.2, the risk-free rate is 12%, the risk premium on the market portfolio Korea is 15%. Assume Kim’s shares
are correctly priced by the market.

Asanka Ranasinghe MBA (Colombo), BBA (Finance), ACMA, CGMA

EDBAS 202 Corporate Financial Management

You are required to;

i. Determine the expected rate of return and standard deviation of the return from the new project.

ii. If the new project requires capital funding equal to 25% of the value of the existing assets of Kim Ltd.,
determine the risk- return characteristics of Kim Ltd after the investment.

iii. What effect will the adoption of the project have on the Beta of Kim Ltd?

Asanka Ranasinghe MBA (Colombo), BBA (Finance), ACMA, CGMA