# 1.

Consider the shares of 2 firms, A and B, with the following characteristics : SECURITY A Expected Return (%) Standard Deviation (%) REQUIRED : a) What is the expected rate of return and the risk of an equally weighted portfolio of A and B if the correlation coefficient between the two shares is 0.45? 8 14 SECURITY B 20 24

b) Calculate the proportion that should be invested in A and B so that the portfolio will have the lowest risk possible.

c) Assuming that the 2 securities are perfectly negatively correlated, what weights for A & B would create a perfectly hedged portfolio?

d) Let us postulate that you have invested one third of your funds in A, and one third in B, and the remainder in another share C. The expected return of the portfolio is 12%. What is the expected return on share C? What is the risk of the portfolio if the standard deviation of C’s return is 25% and the correlation coefficient between all pairs of shares is 0.3?

e) Briefly explain how diversification can reduce the specific risk of a portfolio, but not its market risk.

2

Suppose we have 2 portfolios known to be on the efficient part of the investment opportunity set for a population of 3 stocks, X, Y and Z. The weights, W (proportion of funds invested in each of the 3 securities) for each of the 2 portfolios are as follows : Wx Portfolio 1 Portfolio 2 0.24 0.36 Wy 0.52 0.46 Wz 0.24 0.18

REQUIRED : a) What would be the stock weights for a new portfolio constructed by investing \$4,000 in Portfolio 1 and \$2,000 in Portfolio 2?

You currently have 50% of your wealth in a risk free asset and 50% in the 4 assets below : Expected return (%) A B C D REQUIRED : b) Define Beta and explain how it can be estimated 7.6 12.4 15.6 18.8 β 0.2 0.8 1.2 1.6 Weights 0.1 0.1 0.1 0.2

c) Calculate the risk free rate of return and the expected return on the market portfolio (state any assumptions you may have made).

d) You now want an expected rate of return of 14% from this sum of money. This can be obtained it by selling some of your holding of the risk free asset and using the proceeds to buy the market portfolio. How will this affect the set of weights in your revised portfolio?

e) Calculate the β of the revised portfolio in part d)

f)

Briefly explain the practical limitations of the CAPM.

3

Lion Airways are considering starting a new no frill air service between Singapore & Hong Kong. Two aircrafts are required costing \$6.5m each. If ordered now, they will be delivered in one year’s time, when they must be paid for. When operations begin each aircraft will undertake one daily return journey. It is not certain how many days of the year will be suitable for flying but data available from 3 other major airlines operating between the 2 countries suggest an average of 350 per annum. The remaining 15 days are used to carry out a major service to the aircrafts. Each aircraft has a capacity of 200 passengers and will generate revenue of \$550 per return ticket. An average capacity utilisation of 80% is expected. Construction of the necessary head office building and facilities will cost \$26m and take one year to complete. Half is payable now, and half on completion. The costs of aircraft crews, ground staff and other facilities will be \$26,000 per one way trip (per flying day) and \$13,000 per non-flying day. The management does not expect any major demand for the service to be forthcoming after 5 years. Both the aircrafts and the building can be depreciated for tax purposes, at a rate of 10% of initial cost per annum. After 5 years, the aircrafts should be worth about \$2.6m each and the airport authorities have indicated that they will be willing to pay \$7.8m for the building. Tax is levied at 30%, payable one year in arrears. REQUIRED : a) Should Lion proceed with this project if an 18% return after tax is required? State all your assumptions b) Calculate the payback period and the IRR for the project c) Discuss the advantages and disadvantages of the NPV when compared to nondiscounting techniques that might be used to appraise a capital investment d) Briefly explain the usefulness of the return on capital employed.

4

The company board is keen to adopt the IRR criterion as a screening mechanism for capital investment projects. You are required to provide a detailed explanation of the IRR and to point out and clarify any problems that might arise when using this technique and also explain how these problems might be resolved.

5 a) Describe the efficient market hypothesis (EMH) and distinguish between its 3 forms b) Discuss how the Singapore stock exchange might be tested for semi-strong OR weak form of market efficiency. c) Discuss the relevance and implications of the EMH for the financial manager of a Singaporean public listed company.

6 a) Explain what Financial Institutions are.

b) Discuss the role of Financial Institutions in the functioning of the Financial Markets.

7 a) What is Systematic Risk and how is it distinguished from unique risk?

b) Explain how Portfolio Theory has contributed to the development of Capital Asset Pricing Model.