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Tutorial 3 Risk and Return

This document contains 10 questions related to portfolio theory, CAPM, beta calculation, and cost of capital estimation. The questions cover topics such as calculating portfolio beta based on the betas of individual assets, estimating cost of capital for levered firms, calculating standard deviation of portfolios, and determining maximum allowable beta for a new division to achieve a target required return.

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Vinay Kumar
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87 views3 pages

Tutorial 3 Risk and Return

This document contains 10 questions related to portfolio theory, CAPM, beta calculation, and cost of capital estimation. The questions cover topics such as calculating portfolio beta based on the betas of individual assets, estimating cost of capital for levered firms, calculating standard deviation of portfolios, and determining maximum allowable beta for a new division to achieve a target required return.

Uploaded by

Vinay Kumar
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Q1. Standard deviation of market return is 20%.

XYZ holds a poorly diversified


portfolio which has a standard deviation of 20%. What can you conclude about
the beta of XYZ’s portfolio?

Q2. DEF has a beta of 0.46, market capitalization of 4 crores and debt of 2 crores.
It has three divisions of equal size. It is divesting one of the divisions for Rs.2
crores and acquiring another for Rs.5 crores by taking Rs.3 crores as debt for this
transaction. The division it is divesting is in a business where average unlevered
beta is 0.20 and division it is acquiring is in a business where average unlevered
beta is 0.80. What is the beta of DEF after this acquisition?

Q3. Stock A has an expected return of 12% and standard deviation of 15%. Stock B
has an expected return of 15% and standard deviation of 20%. David invests his
money in a combination of these two stocks such that he has an expected return
of 13.8%. The expected standard deviation of his portfolio is 16.32%. What will be
the standard deviation of Goliath’s portfolio if he is investing in the same two
stocks and his portfolio gives a return of 14.4%?

Q4. State whether TRUE / NOT TRUE

Asset “A” has beta of 1.2. Asset “B” has beta of 0.6. State whether the following
are TRUE or NOT TRUE

a. Asset A is more volatile than Asset B


b. Asset A has higher expected return than Asset B
c. In a regression with individual return as dependent and market return as
independent variable, R square of A is higher than that of B
d. In a regression with individual return as independent and market return as
dependent variable, R square of A is higher than that of B
Q5. A regression of monthly returns of ABC against monthly returns of S&P 500
index generated the following output:

Return of ABC = 3.28% + 1.65 Return on Market

R square = 0.20

The current treasury bond rate is 4.8%. The firm has 26.5 crore shares
outstanding, selling at Rs.30 per share.

a. An analyst has estimated, correctly, that the stock did 51.10% better than
expected annually during the period of the regression. What is the
annualised risk free rate used by the analyst to come up with this estimate?

b. The firm has a debt /equity ratio of 3% and faces a tax rate of 40%. It plans
to issue Rs.200 crore in new debt and acquire a new business for that
amount, with the same level of risk as the firm’s existing business. What
will the beta be after acquisition?

Q6. ABC is a retailing firm, with a debt to equity ratio of 20%. The average
unlevered beta of comparable retailing firms is 1.15. ABC is rated BBB and the
default spread for BBB rated firms is 1% over the treasury bond rate. If the
treasury bond rate is 6.5%, estimate the cost of capital for the firm. Assume that
the market risk premium is 5.5%, and the tax rate is 40%.

Q7. What is the Standard deviation of a very large equally weighted portfolio of
stocks within an industry in which all stocks have standard deviation of 40% and
the average correlation between any two stocks is 60%?

Q8. Stock A has a mean return of 10% and standard deviation of its returns is
20%. Stock B has a mean return of 16% and standard deviation of its returns as
30%. The correlation coefficients between the stocks is -1. What is the risk-free
rate?
Q9. You have an investment of Rs.10,000 invested in Stock A. Risk free rate is 4%.
Stock A has an expected return of 9% and a Standard deviation of 27%. The
market portfolio has an expected return of 10% and Standard deviation of 16%.
Assume CAPM assumptions hold, then find

a. Which portfolio has the lowest possible Standard deviation while having
the same expected return as Stock A? How much is the Standard deviation?
b. Which portfolio has the highest possible expected return while having the
same Standard deviation as Stock A? How much is the return?

Q10. Sun Company, an all equity firm, is considering formation of a new division,
which will increase Sun's assets by 50%. Sun has currently a required return of
18%. If Sun wants to reduce its required rate to 16%, what is the maximum beta
the new division could have? (Risk free = 7%, Market Risk Premium = 5%)

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