BBMF 2093 Corporate Finance: Portfolio Proportion: Amount Invested / Total Amount Invested

BBMF 2093 CORPORATE FINANCE
TUTORIAL 4 PORTFOLIO THEORY
1. Selene Maranjian invests the following sums of money in common stocks having
expected returns as follows:
COMMON STOCK AMOUNT INVESTED EXPECTED RETUN

(TICKER SYMBOL)
One-Legged Chair Company (WOOPS) $6,000 0.14
Acme Explosives Company (KBOOM) $11,000 0.16
Ames-to-Please, Inc. (JUDY) $9,000 0.17
Sisyphus Transport Corporation $7,000 0.13
(UPDWN)
Excelsior Hair Growth, Inc. (SPROUT) $5,000 0.20
In-Your-Face Telemarketing, Inc. $13,000 0.15
(RINGG)
McDonald Farms, Ltd. (EIEIO) $9,000 0.18
(a) What is the expected return (percentage) on her portfolio?
0.1(0.14) + 0.1833(0.16) + 0.15(0.17) + 0.1166(0.13) + 0.0833(0.20) + 0.2166(0.15)

+ 0.15(0.18)
= 16.01%
*portfolio proportion: amount invested / total amount invested
(b) What would be her expected return if she quadrupled her investment in Excelsior Hair
Growth, Inc., while leaving everything else the same?
2. Colours Plc. is considering two mutually exclusive investments: Black and White. The po
ssible net present values for both projects and the associated probabilities are as follows:
(a) Determine the levels of risk of each investment project.
E[R] Black = 0.1(10)+0.5(20)+0.4(25)
=RM21 million
E[R] White = 0.6(15)+0.2(20)+0.2(40)

=RM21 million
E[R] Black = 0.1(10)+0.5(20)+0.4(25)
=RM21 million
E[R] White = 0.6(15)+0.2(20)+0.2(40)

=RM21 million
To determine the levels of risk, we should calculate the standard deviation
SD Black = √ (0.1) ¿ ¿
=√ 19
=RM4.359 million
SD White = √(0.6)(15 − 21)2+(0.2)(20 −21)2+(0.2)(40 −21) 2
= √ 94
= RM9.695 million
(b) Assuming, the management is risk averse, justify the investment it should accept.
Project Black has a lower level of risk so Colours Plc. should accept this project.
Alternatively, the firm has an opportunity to invest in two overseas locations for a planned
expansion of its production facilities. The future returns from the investments depend to a l
arge extent on the economic situation of the countries under consideration. An analysis of t
he expected rates of return under three different scenarios is as follows:
(c) What would be the expected return and standard deviation of the portfolio if the
available funds were split 60% to Region 1 and 40% to Region 2?
E[R] Region 1 =0.3(0.3)+0.4(0.25)+0.3(0.2)

= 0.25
=25%
E[R] Region 2 =0.2(0.5)+0.6(0.3)+0.2(0.1)
=0.3
=30%
The E[R] of the portfolio = 0.6(0.25)+0.4(0.3)

=0.27 / 27%
σ region 1=√ 0.3(0.30 − 0.25) 2+0.4 (0.25 −0.25)2+ 0.3(0.2 −0.25)2
= 0.0387
σ region 2=√ 0.2(0.50 −0.3)2+0.6( 0.3− 0.3)2+0.2(0.1− 0.3) 2
= 0.1265
W1=0.6, W2=0.4 , ER1=25%, ER2= 30% SD1= 3.87%, SD2= 12.65% , CC = 1
Portfolio standard deviation = √ [0.62x (3.87%)2 +0.42(12.6%)2 +2 x 0.6

x0.4 x 3.87%x12.6%x1]
Expected portfolio risk = 7.36%
*correlation coefficient need to multiply standard deviation
While covariance no need
(d) Should the firm consider expanding operations in both the regions? Justify.
In this case, it is adviseble for Colours Plc to diversify its investment into both the
region, as marginal reduction in risk is still higher than the marginal reduction in
expected return.
R1 R2 Portfolio
ER 25% 30% 27%
SD 3.87% 12.6% 7.39%

In this case, it is advisable for Colour Plc to diversify its investment into both the
regions, as marginal reduction in risk is still higher than the marginal reduction in
expected return.
3. The Investment Department of Meakom Bhd has been allocated a fixed capital sum by
the Board of Directors for its capital investments for next year. The department’s manager
has identified three viable capital projects which could enhance the wealth of its
shareholders. However, the funds allocated are sufficient for only two of the capital
projects, which are not divisible and cannot be postponed to a later date. Each project
requires the same amount of investment.
The manager proposes to use portfolio theory to determine which two projects should be
undertaken, based upon an analysis of each project’s as well as the portfolio risk and
return.
The investment department has collected the following data:
The expected return of Project B = 8.6%

The expected return of Project C = 14.2%
The standard deviation of Project B =7%
The standard deviation of Project C =9%
The covariance between projects A and B =0.2642%
The possible investment options are as follows:
Required:
(a) Calculate the expected return and the standard deviation of Project A.
= 0.2(0.22) + 0.6(0.12) + 0.2(-0.03)
=0.11
=11%
= √ 0.2(0.22 −0.11)2+ 0.6(0.12 −0.11)2+0.2( −0.03 −0.11)2
=√ 0.0064
= 0.08 = 8%
(b) Calculate the expected return (i) and standard deviation (ii) of a portfolio consisting of
60% of investment in Project A and the remainder in Project B.
Expected return = 0.6(0.11) + 0.4(0.086)

=0.1004
=10.04%
Portfolio Standard Deviation = √ (0.6)2(0.08)2 + 2(0.6)(0.4)(0.002642) +

(0.4)2(0.07)2
= √ 0.004356
= 0.066 / 6.6%
Portfolio Standard Deviation = √(WA)2(∂A)2 + (WB)2(∂B)2 + 2wAwB (covariance)
(c) Recommend the combination of the investments that the company should choose.
I will recommend the company to choose option 2 (combination of product A and product C).
This is because the standard deviation of this combination is lesser than option 1 and 3. This
means option 2 has lower risk compared to option 1 and 3. Besides, the return of option 2 is
also higher than option 1. After considering having a higher expected return with lower risk, I
will recommend choosing option 2.
(Risk averse)

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BBMF 2093 CORPORATE FINANCE

TUTORIAL 4 PORTFOLIO THEORY

COMMON STOCK AMOUNT INVESTED EXPECTED RETUN

(a) What is the expected return (percentage) on her portfolio?

0.1(0.14) + 0.1833(0.16) + 0.15(0.17) + 0.1166(0.13) + 0.0833(0.20) + 0.2166(0.15)

*portfolio proportion: amount invested / total amount invested

E[R] White = 0.6(15)+0.2(20)+0.2(40)

E[R] White = 0.6(15)+0.2(20)+0.2(40)

To determine the levels of risk, we should calculate the standard deviation

SD White = √(0.6)(15 − 21)2+(0.2)(20 −21)2+(0.2)(40 −21) 2

E[R] Region 1 =0.3(0.3)+0.4(0.25)+0.3(0.2)

The E[R] of the portfolio = 0.6(0.25)+0.4(0.3)

σ region 2=√ 0.2(0.50 −0.3)2+0.6( 0.3− 0.3)2+0.2(0.1− 0.3) 2

W1=0.6, W2=0.4 , ER1=25%, ER2= 30% SD1= 3.87%, SD2= 12.65% , CC = 1

Portfolio standard deviation = √ [0.62x (3.87%)2 +0.42(12.6%)2 +2 x 0.6

Expected portfolio risk = 7.36%

*correlation coefficient need to multiply standard deviation

While covariance no need

ER 25% 30% 27%

SD 3.87% 12.6% 7.39%

The expected return of Project B = 8.6%

The possible investment options are as follows:

= √ 0.2(0.22 −0.11)2+ 0.6(0.12 −0.11)2+0.2( −0.03 −0.11)2

Expected return = 0.6(0.11) + 0.4(0.086)

Portfolio Standard Deviation = √ (0.6)2(0.08)2 + 2(0.6)(0.4)(0.002642) +

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