-UNIVERSITY OF BOTSWANA

FACULTY OF BUSINESS

DEPARTMENT OF ACCOUNTING AND FINANCE

TEST 2 SPECIAL SOLUTIONS

FRONT PAGE

COURSE NO: FIN 300 DATE: APRIL /MAY 2021

TITLE OF PAPER: FINANCIAL MANAGEMENT DURATION: 1 HR

40MINS

SUBJECT: FINANCE

INSTRUCTIONS:

1. There are three (3) questions. Answer all.

2. The question paper carries a total of 40 marks
3. Show all supporting work (including formulae)
3. Neatness and presentation will be considered in grading
4. Give your answer to 2 decimal places where applicable
5. The use of programmable equipment or any prohibited material is
strictly forbidden and constitutes exam misconduct
6. Financial tables are attached at the end

DO NOT OPEN THIS PAPER UNTIL YOU HAVE BEEN TOLD TO DO

SO BY THE INVIGILATOR

No. of pages 5 (Including cover page)

QUESTION 1

There are two securities whose returns are dependent on the state of the
economy and the probability distribution of two securities is given as follows:
 State of Probability of the Rate of Return Rate of Return
economy State Occurring Stock A Stock B
Recession 0.2 -12% 5%
Normal 0.5 40% 15%
Boom 0.3 90% 60%

(a) Calculate the expected return and standard deviation of each security (6
marks)
(b) State which securities you would prefer as an investment and why? (4
marks)

Expected return = k^ = P1k1 + P2k2 +………+Pnkn

(1 mark)
n
K ¿ ∑ PiKi
i=1

Share A k^ = (0.2 x -12%) + (0.5 x 40%) + (0.3 x 90%) = 0.446=0.45

(0.5 mark)

Share B k^ = (0.2x 5%) + (0.5 x 15%) + (0.3 x 60%) =0.265=0.27

(0.5 mark).

Share A Standard deviation (risk)

Probability Rate of (Ki – K^) (Ki – K^)2P

(Pi) Return (Ki) Where K^ =
0.45
0.2 -0.12 -0.57 0.06498
0.5 0.40 -0.05 0.00125
0.3 0.90 0.45 0.06075
Variance
0.12698
Share A Risk Std Dev
0.36=36%
(2 marks)
Share B Standard deviation (risk)

Probability Rate of (Ki – K^)2 (Ki – K^)2P

(Pi) Return (Ki) Where K^ =
0.27
0.2 0.05 -0.22 0.00968
0.5 0.15 -0.12 0.0072
 0.3 0.60 0.33 0.03267

Variance 0.04955
Share B risk Std
Dev 0.22=22%

(2 marks)
a. Which of the two securities would you prefer as an investment and
why?

Coefficient of Variation (CV) = Risk/Return

Share A CV = 36%/45%= 0.80 (1
mark)
Share B CV = 22%/27% = 0.81 (1
mark)
DECISION – choose investment Share A because it has a lower proportion of
risk per unit of return. (2 marks)

QUESTION 2

Investec Botswana is a company that specializes in investment portfolio for

pension fund investors, businesses and off-shore investors. The following is the
investment profile of the company:

Security Amount Invested (P) Stock Beta

Securicor 250,000 1.0
M&S 450,000 1.6
WHS 200,000 0.8
Tesco 100,000 2.0
Delta 500,000 0.7
Nokia 200,000 0.5

The following information is available from the stock market; the risk free rate is
given as 6% and the required rate of return of the Nokia stock is 9.5%.

a) What is the required rate of return for the stocks in the portfolio?(5
marks)
K=Krf+(Km-Krf)B
9.5%=6%+(KM-6%)0.5
Km=13%

Securicor K=6%+(13%-6%)1.0=13% (1 mark each)

M&S k=6%+(7%)1.6=17.2%
 WHS K=6%+(7%)0.8=11.6%
Tesco k=6%+ (7%)2.0=20%
Delta k=6%+(7%)0.7=10.9%
b) What is the portfolio risk? (2
marks)

Security Amount Weights(wi) (1 mark) Stock Beta

Invested (P)
Securicor 250,000 250,000/1,700,000=0.1 1.0
5
M&S 450,000 450,000/1,700,000=0.2 1.6
6
WHS 200,000 200,000/1,700,000=0.1 0.8
2
Tesco 100,000 100,000/1,700,000=0.0 2.0
6
Delta 500,000 500,000/1,700,000=0.2 0.7
9
Nokia 200,000 200,000/1,700,000=0.1 0.5
2

Bp=∑wibi=0.15(1)+0.26(1.6)+0.12(0.8)+0.06(2.0)+0.29(0.7)+0.12(0
.5)
=0.15+0.42+0.10+0.10+0.12+0.20+0.06
=1.05 (1 mark)

c) Calculate the required rate of return on the portfolio (3 marks)

Kp=krf+(km-krf)bp
=6%+(13%-6%)1.15
=6%+(7%)1.05
=13.35%
d) Construct the security market line (SML) for this portfolio (3
marks)
Beta(bi) 0 1 1.05
Required Return 13.35
(ki) 6% 13% %
 SML:Ki=6%+7%bi
Required Re-
Requiredturn
Re- (ki); 14%
f(x) = 0.07 x + 0.06 turn (ki); 13%
R² = 1 Required Return (ki)
SML:Ki=6%+7%bi

Required Re-
turn (ki); 6%

e) According to the CAPM, the expected return on a risky asset

depends on three components. Identify these components and
explain their role in determining expected return.
(6 marks)

Students to explain these;

 KRF =Risk-free rate of return
 bi=Beta coefficient of a security in a portfolio
 KM=Required rate of return on a market portfolio, i.e. a
portfolio constituting of all shares in a market
Therefore: Ki = KRF + (KM – KRF)bi

QUESTION 3

In brief, what is your understanding of the Efficient Markets Hypothesis, in so far

as explaining stock pricing?

This is a fairly broad question which should be approached in a fairly

subjective manner. Most critically, a student should demonstrate some
understanding the relationship between the EMH and share pricing. In
particular, show that under perfectly efficient markets, share prices are on
the mark and hence there are no extraordinary gains to be made. Since all
available information is embodied in the price, speculation does not work.
However, in the real would, markets are not as efficient and hence there is
always room to ‘beat’ the market.
(10 marks)

End of Question Paper