ACCT 5130 – Individual Assignment

Pauis Tatah Mbi

Question 1

a):
The expected return of each stock asset is:
E(RP) = 0.3(0.50) + 0.50(0.15) + 0.20(-0.20)
= 0.15 + 0.075 + (-0.04) = 0.185 Or 18.5%
E(RD) = 0.3(0.25) + 0.50(0.10) + 0.20(0.05)
= 0.075 + 0.05 + 0.01 = 0.135 0r 13.5%

The variance and standard deviation of each stock is:

Variance(P) = 0.30(0.50 – 0.185)2 + 0.50(0.15 – 0.185)2 + 0.20(-.20 – 0.185) 2
= 0.0297675 + 0.0006125 + 0.029645 = 0.060025
Standard deviation (P) = (0.060025)1/2 = 0.245 or 24.50%

Variance(D) = 0.30(0.25 – 0.135)2 + 0.50(0.10 – 0.135)2 + 0.20(0.050 – 0.135) 2

= 0.0039675 + 0.0006125 + 0.001445 = 0.006025
Standard deviation (D) = (0.006025)1/2 = 0.077620873 or 7.76%

b):
i) Wp = 0% & WD =100%
Boom: E(R portfolio) = 0%(0.50) + 100%(0.25) = 0.25 or 25%
Normal: E(R portfolio) = 0%(0.15) + 100%(0.10) = 0.10 or 10%
Recession: E(Rp) = 0%(-0.20) + 100%(0.05) = 0.05 or 5%
And the expected return of the portfolio is:
E(Rp) = 0.30(0.25) + 0.50(0.10) + 0.20(0.05)
= 0.075 + 0.05 + 0.01 = 0.135 or 13.5%

Var(portfolio) = [(0%2 x 0.245)+ (100%2 x 0.0776208732) + 2 x 0%x 100% x

0.245 x 0.077620873 x 0.20] = 0.006025
Standard deviation (portfolio) = (0.006025)1/2 = 0.0776 or 7.76%

ii) Wp = 25% & WD =75%

Boom: E(R portfolio) = 25%(0.50) + 75%(0.25) = 0.3125 or 31.25%
Normal: E(R portfolio) = 25%(0.15) + 75%(0.10) = 0.1125 or 11.25%
Recession: E(Rp) = 25%(-0.20) + 75%(0.05) = -0.0125 or -1.25%
And the expected return of the portfolio is:
E(Rp) = 0.30(0.3125) + 0.50(0.1125) + 0.20(-0.0125)
= 0.09375 + 0.05625 + (-0.0025) = 0.1475 or 14.75%

Var(portfolio) = [(0.252 x 0.2452) + (0.752 x 0.0776208732) + 2 x 0.25 x 0.75 x

0.245 x 0.077620873x 0.20]
= (0.0625 x 0.060025) + (0.5625 x 0.006025)+0.001426283
= 0.00375+0.003389+0.00143 = 0.008569
Standard deviation (portfolio) = (0.008569)1/2 = 0.09257 or 9.26%

iii) Wp = 50% & WD =50%

Boom: E(R portfolio) = 0.50(0.50) + 0.50(0.25) = 0.375 or 37.5%
Normal: E(R portfolio) = 0.50(0.15) + 0.50(0.10) = 0.125 or 12.50%
Recession: E(Rp) = 0.50(-0.20) + 0.50(0.05) = -0.075 or -7.50%
And the expected return of the portfolio is:
E(Rp) = 0.30(0.375) + 0.50(0.125) + 0.20(-0.075)
= 0.1125 + 0.0625 + (-0.015) = 0.160 or 16.0%

Var(portfolio) = [(0.502 x 0.2452) + (0.502 x 0.0776208732) + 2 x 0.50 x 0.50 x

0.245 x 0.077620873 x 0.20]
= (0.25 x 0.060025) + (0.25 x 0.006025) +0.0190
= 0.01501+0.00151+0.00190 = 0.01842
Standard deviation (portfolio) = (0.01842)1/2 = 0.13572l or 13.57%

iv) Wp = 75% & WD =25%

Boom: E(R portfolio) = 0.75(0.50) + 0.25(0.25)
= 0.375 + 0.0625 = 0.4375 or 43.75%

Normal: E(R portfolio) = 0.75(0.15) + 0.25(0.10)

= 0.1125 + 0.025 = 0.1375 or 13.75%
Recession: E(Rp) = 0.75(-0.20) + 0.25(0.05)
-0.15 + 0.0125 = -0.1375 or -13.75%
And the expected return of the portfolio is:
E(Rp) = 0.30(0.4375) + 0.50(0.1375) + 0.20(-0.1375)
= 0.13125 + 0.06875 + (-0.0275) = 0.1725 or 17.25%

Var(portfolio) = [(0.752 x 0.2452) + (0.252 x 0.0776208732) + 2 x 0.75 x 0.25 x

0.245 x 0.077620873 x 0.20]
= (0.5625 x 0.060025) + (0.0625 x 0.006025)+0.00143
= 0.03376+0.00038+0.00143 = 0.03557
Standard deviation (portfolio) = (0.03557)1/2 = 0.18860 or 18.86%

v) Wp = 100% & WD =0%

Boom: E(R portfolio) = 100%(0.50) + 0%(0.25) = 0.50 or 50%
Normal: E(R portfolio) = 100%(0.15) + 50%(0.10) = 0.15 or 15%
Recession: E(Rp) = 100%(-0.20) + 0%(0.05) = -0.20 or -20%
And the expected return of the portfolio is:
E(Rp) = 0.30(0.50) + 0.50(0.15) + 0.20(-0.20)
= 0.15 + 0.075 + (-0.04) = 0.185 or 18.5%

Var(portfolio) = [(100%2 x 0.2452 )+ (0%2 x 0.0776208732) + 2 x 100%x 0% x

0.077460 x 0.17655 x 0.20] = 0.06003
Standard deviation (portfolio) = (0.06003)1/2 = 0.2450 or 24.50%

c):
Diversifiable or unsystematic risk are risk that can be partially or
eliminated by diversification of the portfolio, while non-diversifiable or
systematic risks are the risks that cannot be diversified away. Unsystematic
risk takes place due to internal or organizational or micro-economic factors
while systematic risks take place due to external factors or macro-economic
factors. Systematic risks are measured by beta while unsystematic risk can
be measured by subtracting systematic risk from total risk. The beta
coefficient is used to measure systematic risk. Beta is a measure of a stock's
volatility in relation to the market. It essentially measures the relative risk
exposure of holding a particular stock or sector in relation to the market.
Beta, the relevant measure of risk because in a well-diversified portfolio,
the unsystematic risk of a stock is eliminated, and only systematic risk is
left. Non - diversifiable risk is the risk common to the entire class of assets
or liabilities. Diversifiable risk refers to the portion risk that is associated to
a particular asset and can be eliminated through diversification.
Diversification is a technique that reduces risk by allocating investments
across various financial instruments, industries, and other categories. It
aims to minimize losses by investing in different areas that would each
react differently to the same event. This reduction in risk arises because
worse than expected returns from one asset are offset by better-than-
expected returns from another.

d):

βportfolio = (0.20)( βPrestine) + (0.80)(βDefinite)

= (0.20) (1.58) +(0.80) (0.75) = 0.92
e):
If 20% is invested in Prestine
ERP = (0.2)(0.15) + (1-0.2)(0.09) = 0.102 or 10.20%
BP = (0.2)(1.58)+(1-0.2)(0) = 0.32

If 80% is invested in Definite

ERP = (0.8)(0.15)+(1-0.80)(0.09) = 13.80%
BP = (0.8)(0.75)+(1-0.08)(0) = 0.60

Reward-to-risk ratio = (ER – Rf)/β

Pristine = (0.1850 – 0.09)/1.58 = 6%
Definite = (0.1350 – 0.09)/0.75 = 6%

For the stocks to be fairly valued, they must offer risk a risk-free rate of
9%.
(0.1850 – Rf)/1.58 = (0.1350 – Rf)/0.75
(0.1850)-(0.1350)(2.12)= Rf-Rf(2.12)
1.12Rf = 0.1012
Rf = 0.1012/1.12 = 0.090357 or 9.04%
Thus, we can conclude that the stocks are fairly valued.
Question 2.
1. What is CUIT’s cost of capital (WACC) for this project?

n= 10 years
PMT = 3% X 1,000 = 30
PV = 1,000
FV = 1,000

YTM = 30 + (1000 – 1000)/10 ÷ (1000+1000)/2

= 30/1000
YTM = 3.00%
Kd = 3.00% x (1-34%) = 1.98%

Levered Beta = Unlevered Beta (1 + (1-t)(Debt/Equity))

=0.458(1+ (1-34%)(.75/.25) = 1.36

KE = Rf + βE X [E(RM) – Rf]
KE = 0.01 + 1.36 (0.138 – 0.01) = 0.184 or 18.41

WACC = [Wd × Kd + We ×Ke ]

WACC = [ 0.75 x 0.0198 + 0.25 x 0.184]
WACC = 0.01485 + 0.0460
WACC = 6.1% or 0.061
WAFC = WD × FCD + WE ×FCE
WAFC = 0.75 x 0.015 + 0.25 x 0.025 =
= 0.01125 + 0.00625 = 1.75% or 0.0175
Floatation adjustment = 40,000,000 ÷ ( 1- 0.0175) = 40,000,000/0.9825
Floatation adjustment = $40,712,468.

2. What are the cash flows from assets for the project in years 1-10?
see excel file attached

3. What is the PV of CCA tax shield?

see excel file attached

4. Should CUIT proceed with this project

see excel file attached