Finance 1 for IBA –

Tutorial 5
P R A N AV D E S A I
JOREN KOËTER
LINGBO SHEN
11.2 a) Portfolio weights:
You own three stocks: 600 shares of
Apple Computer, 10,000 shares of
Cisco Systems, and 5000 shares of
Colgate-Palmolive. The current share
prices and expected returns of Apple,
Cisco, and Colgate-Palmolive are,
respectively, $547, $18, $95 and 12%,
10%, 8%.

a) What are the portfolio weights of b) Expected portfolio return:

the three stocks in your portfolio?

b) What is the expected return of

your portfolio?

c) Suppose the price of Apple stock

goes up by $20, Cisco rises by $7,
and Colgate-Palmolive falls by
$14. What are the new portfolio
weights?

d) Assuming the stocks’ expected

returns remain the same, what is
the expected return of the portfolio
at the new prices?
11.2-cont c) Portfolio weights:
You own three stocks: 600 shares of
Apple Computer, 10,000 shares of
Cisco Systems, and 5000 shares of
Colgate-Palmolive. The current share
prices and expected returns of Apple,
Cisco, and Colgate-Palmolive are,
respectively, $547, $18, $95 and 12%,
10%, 8%.

a) What are the portfolio weights of d) Expected portfolio return:

the three stocks in your portfolio?

b) What is the expected return of

your portfolio?

c) Suppose the price of Apple stock

goes up by $20, Cisco rises by $7,
and Colgate-Palmolive falls by
$14. What are the new portfolio
weights?

d) Assuming the stocks’ expected

returns remain the same, what is
the expected return of the portfolio
at the new prices?
11.5 a) Average return and volatility:
Using the data in the following table,
estimate

(a) The average return and volatility

for each stock

(b) The covariance between the

stocks.

(c) The correlation between these two

stocks.
11.5-cont b) Covariance:
Using the data in the following table,
estimate

(a) The average return and volatility

for each stock

(b) The covariance between the

stocks. c) Correlation:
(c) The correlation between these two
stocks.
11.6 a) Portfolio Returns:

Use the data in Problem 5, consider a

portfolio that maintains a 50% weight Year 2010 2011 2012 2013 2014 2015
on stock A and a 50% weight on stock Stock A -0.1 0.2 0.05 -0.05 0.02 0.09
B.
Stock B 0.21 0.07 0.3 -0.03 -0.08 0.25
a) What is the return each year of Portfolio 0.055 0.135 0.175 -0.04 -0.03 0.17
this portfolio?

b) Based on your results from part a, b) Portfolio average return and volatility:
compute the average return and
volatility of the portfolio.

c) Show that (i) the average return of

the portfolio is equal to the
average of the average returns of
the two stocks, and (ii) the
volatility of the portfolio equals
the same result as from the
calculation in Eq. 11.9.

d) Explain why the portfolio has a

lower volatility than the average
volatility of the two stocks.
11.6 c) Alternative calculation
Use the data in Problem 5, consider a
portfolio that maintains a 50% weight
on stock A and a 50% weight on stock
B.

a) What is the return each year of

this portfolio?

b) Based on your results from part a,

compute the average return and
volatility of the portfolio.

c) Show that (i) the average return of

the portfolio is equal to the
average of the average returns of d) The volatility is lower since some of the volatility is
the two stocks, and (ii) the
volatility of the portfolio equals diversified away.
the same result as from the
calculation in Eq. 11.9.

d) Explain why the portfolio has a

lower volatility than the average
volatility of the two stocks.
11.19 Marginal contribution to risk:
Stock A has a volatility of 58% and a
correlation of 27% with your current
portfolio. Stock B has a volatility of
97% and a correlation of 28% with For A:
your current portfolio. You currently
hold both stocks. Which will increase For B:
the volatility of your portfolio:

a) selling a small amount of stock B

and investing the proceeds in Volatility increases if we sell A and buy B.
stock A.

or

b) selling a small amount of stock A

and investing the proceeds in
stock B?
11.22 a) Using the definition of variance of a portfolio:
Suppose Intel’s stock has an expected
return of 26% and a volatility of 50%,
while Coca-Cola’s has an expected
return of 6% and volatility of 25%. If
these two stocks were perfectly
negatively correlated (i.e., their
correlation coefficient is −1)

a) Calculate the portfolio weights

that remove all risk. We need to solve:
b) If there are no arbitrage
opportunities, what is the risk-free
rate of interest in this economy?

The solution:
b) The portfolio in (a), reduces the variance to 0, therefore, we
created a risk free asset. It’s return must be:
11.36 To answer the question, we need to calculate the Sharpe Ratios of
the funds:
Assume the risk-free rate is 4%. You
are a financial advisor, and must
choose one of the funds below to
recommend to each of your clients.
Whichever fund you recommend, your
clients will then combine it with risk-
free borrowing and lending depending
on their desired level of risk.

Fund B gives the highest Sharpe ratio.

12.2
Suppose the market portfolio has an
expected return of 10% and a volatility
of 20%, while Microsoft’s stock has a
volatility of 30%.
a) Given its higher volatility should
we expect Microsoft to have an
equity cost of capital that is higher
than 10%?
a) No, the volatility of the stock is comprised of both systemic
risk that is correlated with the market, and idiosyncratic risk
which is diversifiable. In the extreme case that the stock is
not correlated with the marked, there won’t be any effect on
the cost of capital.
b) The of Microsoft should be exactly as the of the market
(1).

b) What would have to be true for

Microsoft’s equity cost of capital
to be equal to 10%?
12.16
During the recession in mid-2009,
homebuilder KB Home had
outstanding 7-year bonds with a yield
to maturity of 8.7% and a BB rating. If
corresponding risk-free rates were
3.5%, and the market risk premium
was 5.1%, estimate the expected return
of KB Home’s debt using two different
methods. How do your results
compare?
12.16 Method 1 (Risky Debt Approach):
During the recession in mid-2009,
homebuilder KB Home had
outstanding 7-year bonds with a yield
to maturity of 8.7% and a BB rating. If
corresponding risk-free rates were Method 2 (CAPM Approach):
3.5%, and the market risk premium
was 5.1%, estimate the expected return
of KB Home’s debt using two different
methods. How do your results
compare?
12.18 Cost of capital:
Your firm is planning to invest in an
automated packaging plant. Harburtin
Industries is an all-equity firm that
specializes in this business. Suppose
Harburtin’s equity beta is 0.88, the
risk-free rate is 3.9%, and the market
risk premium is 4.9%. If your firm’s
project is all equity financed, estimate
its cost of capital.
12.25 a) Solve in several steps:
Your company operates a steel plant. On Calculate the free cash flows:
average, revenues from the plant are $41
million per year. All of the plants costs
are variable costs and are consistently
78% of revenues, including energy costs
associated with powering the plant,
which represent one quarter of the Calculate the cost of capital:
plant’s costs, or an average of $8 million
per year. Suppose the plant has an asset
beta of 1.13, the risk-free rate is 4%, and
the market risk premium is 4%. The tax
rate is 33%, and there are no other costs.
Discounting to infinity:

a) Estimate the value of the plant today

assuming no growth.
b) Solution:
b) Suppose you enter a long-term
contract which will supply all of the
plant’s energy needs for a fixed cost
of $3 million per year (before tax).
What is the value of the plant if you
take this contract?

c) How would taking the contract in

(b) change the plant’s cost of
c) It depends on the correlation of the assets with the energy costs.
capital? Explain.