Financial Management 2019

TUTORIAL – Lecture 5 & 6

1. Textbook:

Chapter 11: 7, 9, 13, 15, 18, 20, 22, 23

Chapter 12: 2, 6, 19, 30, 31, 23, 24

Chapter 13: 2, 4, 6, 8, 14, 11, 22, 24

2. You intend to make an investment in one stock and have the following stocks to choose from:
Expected Standard
Stock Return Deviation
A 20% p.a. 10% p.a.
B 30% p.a. 50% p.a.
C 15% p.a. 12% p.a.
D 20% p.a. 15% p.a.
E 35% p.a. 40% p.a.
F 25% p.a. 15% p.a.

Since every person's preferred investment will differ, depending on their level of risk aversion, we cannot
say for certain which stock you will choose. The risk-return characteristics of some stocks, however,
clearly dominate others.
a. Begin by plotting each stock on a graph with risk (standard deviation) on the horizontal axis and
expected return on vertical axis. Just plot a single point for each stock.
b. If you had to choose just between stocks A and D, which dominates? Explain.
c. If you had to choose just between stocks D and E, which dominates? Explain.
d. If you had to choose just between stocks B and E, which dominates? Explain.
e. If you had to choose just between stocks A and C, which dominates? Explain.
f. If you had to choose just between stocks A and F, which dominates? How about E and F? How
about C and D? Explain.

3. You plan to combine the following two stocks into a portfolio, with 25% in Stock 1 and 75% in Stock 2:

Expected Variance
Stock Return 2
1 10% 0.0064
2 23% 0.0144

1, 2  1.0
a. Assume the correlation between the two stocks is . Calculate the expected return and
risk (ie. standard deviation) of the portfolio.
  0.30
b. Now assume that the correlation between the stocks is more typical: 1,2 . Re-calculate the
expected return and risk of the portfolio. Why is the risk lower now than in (a)?

4. Use the same data table for Stocks 1 and 2 as Question 2, and assume the correlation between stocks is
0.30. You are less risk-averse than the average investor, and are aiming to construct a portfolio

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comprising Stocks 1 and 2 that has an expected return of 20.50%. You realize this portfolio will have a
higher risk, but are happy to tolerate it.
a. What weighting in each stock will give a portfolio with the desired expected return?
b. Calculate the risk (i.e., standard deviation) of this portfolio.

5. Three stocks have the following risk-return characteristics:

Stock Expected Standard

Return Deviation
A 20% 38%
B 12% 15%
C 15% 28%
\
a. If there is no risk-free asset, does any of these three stocks clearly dominate any other in terms of
risk and return?
Now assume there is a risk-free asset with a guaranteed return of 5% p.a. You can now form a portfolio
consisting of one risky asset plus the risk-free asset. You are willing to bear a standard deviation of 25%
p.a. for your portfolio.
b. For a portfolio comprising Stock A and the risk-free asset, what weights will you assign to each in
order to get the desired level of risk?

6. Consider the following information for Stocks 1 and 2:

Expected Standard
Stock Return Deviation
1 20% 40%
2 12% 20%

The correlation between the returns of these two stocks is 0.3.

a. How will you divide your money between Stocks 1 and 2 if your aim is to achieve a portfolio with an
expected return of 18% p.a.? That is, what are the weights assigned to each stock? Also take note
of the risk (i.e., standard deviation) of this portfolio.
Now assume that, in addition to the two risky stocks, there is a risk-free investment with a guaranteed
return of 5% p.a. This gives you the opportunity to use the risk-free asset in your portfolio.
b. You create a portfolio with 79.65% of your funds invested in Stock 1 and 20.35% invested in the risk-
free asset. Calculate the expected return and standard deviation of this portfolio.
c. How does the portfolio in (b) compare to the portfolio in (a)? Which portfolio do you prefer? Why?

7. Assume the following data:

 the market risk premium is 7% p.a.
 the variance of the return on the market is 0.14, and
 the risk-free rate is 6% p.a.
Your task is to determine a discount rate appropriate for a single company, BHP. If the variance of BHP's
return is 0.30 and its beta is 1.20, what is the expected return of BHP?

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8.
 
The risk-freerate
2
m
is 7% p.a. The expected return on the market portfolio is 12% p.a., and the variance of

this return is 0.09.

You are examining two stocks: A and B. The standard deviations of the return on Stocks A and B are 50%
p.a. and 20% p.a. respectively. The correlation between each stock and the market is:
 A ,m  0.90, B ,m  0.60
.
a. Calculate the beta of each stock.
b. Calculate the expected return of each stock
c. You construct a portfolio with 60% of your money in Stock A and 40% in Stock B. What is the beta
of this portfolio? What is the expected return of this portfolio?

9. In the following table, X, Y, and Z refer to stocks, while M refers to the market portfolio. The following
partially complete information is available:

Standard Expected Covariance

Deviation Return between
Stock and Market
X 0.1 ? 0.01
Y 0.2 ? 0.025
Z ? 0.216 0.052
M 0.1414 0.120 n/a

The correlation between Stocks X and Y is 0.60.

a. Calculate the betas of Stocks X and Y.
b. Calculate the beta of a new portfolio comprising 80% in X and 20% in Y.
c. What is the risk-free rate of return?
d. What is the expected return on the new portfolio in (b)?

10. In a small economy, the market portfolio comprises shares in only three companies: D, E and F. Details
are set out in the table below.

Company name Shares issued Price per share Expected return

D 1,000,000 $ 2.00 8%
E 500,000 $ 8.00 10%
F 1,600,000 $ 2.50 21%

There is also a risk-free asset that offers a return of 4%.

a. Calculate the expected return on the market portfolio.
b. Assume that the capital asset pricing model applies in this market; calculate the beta of company E.

11. You are currently planning an investment strategy designed to partially finance your eight-year-old child's
education. You have $10,000 to invest and your child will begin university studies ten years from now.
Your financial advisor recommends that you buy some Telstra shares. Telstra shares have a beta of 0.9
and the returns on Telstra shares have a standard deviation of 40% p.a. The riskless rate of interest is 5%
p.a. and the market risk premium is 7% p.a. The standard deviation of the return on the market is 20%
p.a.

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a. If you follow the advice of your financial advisor, how much do you expect to have available when
your child begins university?
b. You become aware that your bank is marketing an Australian Equities Index Fund. The goal of this
fund is to exactly match the performance of the All Ordinaries Index (a broad stock market index).
If you invest in this fund, rather than the Telstra shares, how much do you expect to have available
when your child enters university?
c. Finally, a colleague suggests that you shouldn't limit yourself to choosing between investing
everything in Telstra or everything in the index fund. He suggests that you can do even better by
diversifying. In particular, he suggests an equally-weighted portfolio consisting of $5,000 invested
in Telstra shares and $5,000 invested in the index fund. What do you think about your colleague's
advice?

12.
a. Calculate the WACC of Pippin Ltd, using the following information:
Balance sheet extract
Liabilities
10% debentures ($100 par) $50,000,000

Shareholders' funds
Paid-up capital - ordinary shares ($1 par) $30,000,000
Additional information
 Ordinary shares pay a dividend of 68 cents per year, and are expected to pay the same
dividend amount indefinitely.
 Commonwealth government bonds trade at 5% p.a. (this is an annual, not semi-annual, yield).
 The return on the market portfolio is 13%
 Pippin Ltd's beta is 1.5.
 Its debentures are priced at $106.
 The current return on Pippin Ltd debentures is 2% p.a. above the government bond rate (this
is also expressed as an annual rate).
 No company or personal taxes are levied.
 The existing capital structure is unlikely to change.
b. Explain how and why Pippin Ltd might use the WACC you've just computed.
c. Ash Ltd, a privately held firm, is in the same industry as Pippin Ltd. Ash's operations are primarily
in rural and regional areas. Ash is computing its WACC, but feels that they should be using a higher
beta than Pippin Ltd for the following reasons:
 Ash faces a higher risk of bush fires
 Due to it's rural locations, storm damage is more likely to affect the company's assets
In your opinion, is this reasoning valid? Explain

13. Big Company LTD is investigating whether or not to proceed with project X. It is considered that project
X is of the same nature of business as all existing operations and as a result the firm present WACC can be
used to calculate its viability.
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The cash flows associated with the project are as follows:

Year 0 1 2 3 4
Net Cash -20,000 2000 5000 5000 15,000
Flow

Other information
BALANCE SHEET OF BIG COMPANY ($ 000's)
Current Assets 10,000 Current Liabilities 8,000
Net fixed Assets 25,000 Long-term debt 10,000
Investments 15,000 Deferred taxes 3,000
Shareholders' equity 30,000
Total 50,000 Total 50,000

Corporate Tax Rate 30%

Number of shares on issue 10 million
Current Share Price $ 7.25
Equity Beta 1.47
Expected Return on the Market 12%
Risk Free Rate applicable 7%

Long Term Debt consists of "Junk" Bonds issued at a face value of $7 million. These pay interest semi-
annually at a rate of 16% p.a. (compounding semi-annually). They have 3 years to maturity and a coupon
payment was made yesterday. Long Term Debt also includes a secured liability to Huge Company Ltd
which currently sits in the books at $3 million. Interest is payable annually on this at a fixed rate of 10%
p.a. (which is also the current market rate for this liability). The market yield on the junk bonds is 18% p.a.
(compounding semi-annually)
Compute the WACC of Big Company and determine the project's NPV.

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