CORPORATE FINANCE (UKFF3013)

JAN 2022 TRIMESTER

TUTORIAL 10 (WEEK STARTING 28 MAC 2022)
PORTFOLIO THEORY AND THE CAPITAL ASSET PRICING MODEL
(CHAPTER 8)

QUESTION 1

A multinational company is thinking of investing in two overseas locations for

a planned expansion of its production facilities. The future returns from the
investments depend to a large extent on the economic situation of the
countries under consideration. An analysis of the expected rates of return
under three different scenarios is as follows:
Probability Expected return of country A Expected return of country B

0.3 20% 10%

0.3 10% 20%

0.4 15% 20%

(a) Calculate the mean return and the standard deviation of the returns
from the investment in each country.
(b) What would be the expected return and standard deviation of the
portfolio if the available funds were split 20% to country A and 80% to
country B, and the correlation between returns of the two countries are:
(i) 0
(ii) +1
(iii) –1
Give your comment.

Answers:

(a) Mean return from investment in each country

Prob Expected return of Mean return Expected return of Mean returnB
company A A country B
0.3 20% 6 10% 3

0.3 10% 3 20% 6

0.4 15% 6 20% 8

15% 17%

Standard Deviation of returns from each country

σ A=√ ( 20−15 ) 0 .3+ ( 10−15 ) 0 . 3+ ( 15−15 ) 0 . 4=3 .87 %
2 2 2

σ B=√ ( 10−17 ) 0 .3+ ( 20−17 ) 0 .3+ ( 20−17 ) 0. 4=4 . 58 %

2 2 2

1|Page
 CORPORATE FINANCE (UKFF3013)
JAN 2022 TRIMESTER
TUTORIAL 10 (WEEK STARTING 28 MAC 2022)
PORTFOLIO THEORY AND THE CAPITAL ASSET PRICING MODEL
(CHAPTER 8)

(b) Portfolio expected return and standard deviation

(i) Zero correlation

k̄ P=0 . 2 ( 15 ) +0 .8 (17)=16 .6 %

σ p =√ 0.22 (3.87)2 +0.82 (4.58)2 +2(0.2)(0.8)(0)(3.87)(4.58)=3.74 %

(ii) +1 correlation
k̄ P=0 . 2 ( 15 ) +0 .8 (17)=16 .6 %

σ p =√ 0.22 (3.87)2 +0.82 (4.58)2 +2(0.2)(0.8)(1)(3.87 )( 4.58)=4.44 %

(iii) -1 correlation
σ p=√ 0.22 (3.87)2+0.82 (4.58)2+2(0.2)(0.8)(1)(3.87)(4.58)=4.44%

σ p =√ 0.22 (3.87)2 +0.82 (4.58)2 +2(0.2)(0.8)(−1)(3.87 )( 4.58)=2.89%

Standard deviation of portfolio will be lowest when the correlation between

returns of the two assets is perfectly negatively correlated. To diversify risk,
investors should invest in assets that have negative correlation or to a lesser
extent low positive correlation. Risk (measured by standard deviation) could
be reduced by combining negatively correlated assets or low positive
correlated assets (diversification).

QUESTION 2

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:

2|Page
 CORPORATE FINANCE (UKFF3013)
JAN 2022 TRIMESTER
TUTORIAL 10 (WEEK STARTING 28 MAC 2022)
PORTFOLIO THEORY AND THE CAPITAL ASSET PRICING MODEL
(CHAPTER 8)

State of the economy Probability Return on Project A

(%)

Boom 0.20 22

Normal 0.60 12

Recession 0.20 -3

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 =26.42%

The possible investment options are as follows:

Portfolio
Return Standard
Deviation
Option 1 Projects A and B (a) (b)

Option 2 Projects A and C 12.26 5.23

Option 3 Projects B and C 15.08 9.26

i. Calculate the expected return and the standard deviation of Project A.

ii. Calculate the (a) expected return; and (b) standard deviation of a portfolio
consisting of 60% of investment in Project A and the remainder in Project
B.
iii. Recommend the combination of the investments that the company should
choose.

SUGGESTED ANSWER

3|Page
 CORPORATE FINANCE (UKFF3013)
JAN 2022 TRIMESTER
TUTORIAL 10 (WEEK STARTING 28 MAC 2022)
PORTFOLIO THEORY AND THE CAPITAL ASSET PRICING MODEL
(CHAPTER 8)

(i)Project A

Econom Probabilit RA P× RA % P (RA - RA)2

y y
(P)

Boom 0.2 22 0.2×22 4.4 0.2(22-11)2=24.2

Normal 0.6 12 0.6×13 7.2 0.6(12-11)2=0.6

Recessio 0.2 -3 0.2×3 -0.6 0.2(3-11)2 =39.2

n

ΣP× RA ΣP (RA -R
=11 A)2=(64)0.5

Expected return (R A) = Σ P× RA =11%

Standard deviation(σA) = √ΣP (RA – RA2) = 8%

(ii)
Proportion: 0.6 in (A) 0.4 in (B)
Portfolio returns (Rp) =0.6(11) + 0.4(8.6) =6.6 + 3.44 = 10.04%
Portfolio standard deviation (σp) = √(0.6)2 (8)2 + 2(0.6)(0.4)(26.42) + (0.4)2 (7)2
= 6.6%

(iii)

Combination of Portfolio return% Portfolio standard

projects deviation%
A&B 10.04 6.60

A&C 12.26 5.23

B&C 15.08 9.26

A risk adverse investor will choose projects A & C because the portfolio
standard deviation is the lowest. However, a risk taker will invest in projects B
& C because it gives highest return.

QUESTION 3

4|Page
 CORPORATE FINANCE (UKFF3013)
JAN 2022 TRIMESTER
TUTORIAL 10 (WEEK STARTING 28 MAC 2022)
PORTFOLIO THEORY AND THE CAPITAL ASSET PRICING MODEL
(CHAPTER 8)

McGee Corporation has in its portfolio three stocks with the following
investments and Beta values.

Stock Beta Investments

T 0.6 200,000
U 1.5 400,000
V 2.0 100,000
Total investments 700,000

Assume CAPM is true. The market has a return of 16 percent and the risk-
free rate is 6 percent.(a) You are required to: Rf + β (RM -Rf)

i Calculate the required return of each stock.

ii What can you conclude from the calculation?

Stock Required Return

T 6% + (16% - 6%) 0.6 12%
U 6% + (16% - 6%) 1.5 21%
V 6% + (16% - 6%) 2.0 26%
COMMENT From the above calculations we can conclude that in
general investors are risk averse. They are willing to take
more risk if they can be compensated with a higher return.
In the above the risk is represented by the beta factor. The
higher the beta, the higher is the required return.

ii. Determine the Beta value of the portfolio.

Stock Investment (Weight) Beta Weighted Beta

T 200,000/700,000 = 0.29 0.6 0.174
U 400,000/700,000 = 0.57 1.5 0.855
V 100,000/700,000 = 0.14 2.0 0.28
Portfolio Beta 1.309

iii. Calculate the required rate of return of the portfolio. Rf + β x (Rm – Rf)

Required return of the 6% + (16% -6%) 1.309 19.09%

5|Page
 CORPORATE FINANCE (UKFF3013)
JAN 2022 TRIMESTER
TUTORIAL 10 (WEEK STARTING 28 MAC 2022)
PORTFOLIO THEORY AND THE CAPITAL ASSET PRICING MODEL
(CHAPTER 8)

portfolio

QUESTION 4

Explain the concept of efficient portfolio.

SUGGESTED ANSWER:

According to the portfolio theory, investors are able to choose various

combinations of securities to form portfolios. The various combinations will
produce portfolios of different expected returns and standard deviations.
Those combinations that lie along the upper border to the right of the feasible
set are efficient portfolios. For any given standard deviation, the portfolio will
offer the maximum expected return and for a given expected return, the
portfolios will have the lowest risk.

QUESTION 5

Required:

(a) Explain what is represented by the family of curves Uo-U 3 and X1-X3,
discussing both the position and the shape of the curves.

6|Page
 CORPORATE FINANCE (UKFF3013)
JAN 2022 TRIMESTER
TUTORIAL 10 (WEEK STARTING 28 MAC 2022)
PORTFOLIO THEORY AND THE CAPITAL ASSET PRICING MODEL
(CHAPTER 8)

(b) Discuss the meaning and significance of the points A, B, C and D and
explain how an investor can locate themselves at these points.

SUGGESTED ANSWER

(a) The following points need to be referred to:

Curves are the indifference curves (utility curves) of two investors – U
curves for a risk averse investor and X curves for a more risk loving
investor
Along a curve utility is constant – as an investor faces more risk they need
progressively more return (diminishing marginal rate of substitution) to
compensate and keep their utility constant
Investors want to move northwest in the diagram i.e. higher return for less
risk – this is why the curves radiate out from here.
Investor U’s curves steepen quicker than investor X’s due to investor U
being more risk averse

(b) Point A: this corresponds to the risk-free rate of return as approximated

by the yield to maturity on government treasury bills. An investor would
locate himself here if her is totally risk averse, with his portfolio consisting
totally of government treasury bills
Point B: this represents the optimal combination of the market portfolio
and treasury bills for the moderately risk averse investor U i.e. the point of
tangency between the investor’s curves and the Capital Market Line
(CML).

Point C: represents the market portfolio itself – the optimal combination

of risky investments for an investor. It is found by swinging a line around
from the risk-free rate until the line is tangent with the efficient frontier.

Point D: represents the optimal point for a risk-loving investor who puts
all their money in the market portfolio (risky assets) and then borrows at
the risk free rate of return – investing this money in the market portfolio as
well

QUESTION 6

Comment on the proposition that diversification at corporate level is of no

value to the company’s shareholders.

SUGGESTED ANSWER

The management of a company may feel that shareholders’ long-term

interests will be best served by spreading risk through diversification, say
perhaps of investment projects. However, a shareholder with a well-

7|Page
 CORPORATE FINANCE (UKFF3013)
JAN 2022 TRIMESTER
TUTORIAL 10 (WEEK STARTING 28 MAC 2022)
PORTFOLIO THEORY AND THE CAPITAL ASSET PRICING MODEL
(CHAPTER 8)

diversified portfolio of investments will already have eliminated unsystematic

risk. For such an investor, diversification at corporate level is of no interest.

For an investor who does not hold a well-diversified portfolio of investments

and who has not eliminated unsystematic risk, diversification at corporate
level may be of some value.

QUESTION 7

Critically discuss the significance of the capital market line (CML) in the theory
of portfolio investment. Illustrate with a diagram depicting the CML.

SUGGESTED ANSWER

Students should discuss some or all of the following matters:

 Investors are assumed to be risk-averse utility maximizers;
 Utility is maximized by minimizing the risk for a given level of return or
maximizing return for a given level of risk;
 In the absence of the risk-free asset, the set of portfolios that maximize
utility are situated on the efficient frontier;
 The introduction of the risk-free asset means that the set of utility-
maximizing portfolios lies on the line tangential to the efficient frontier that
intercepts the risk-free rate of return;
 This line, the capital market line, consist of the set of portfolios based on
varying combinations of the market portfolio and the risk-free asset.

QUESTION 8

Explain the limitations of Capital Asset Pricing Model (CAPM).

SUGGESTED ANSWER

CAPM = Rf + β (Rm – Rf)

The limitations of using the CAPM in investment appraisal are both practical
and theoretical in nature. From a practical point of view, there are difficulties
8|Page
 CORPORATE FINANCE (UKFF3013)
JAN 2022 TRIMESTER
TUTORIAL 10 (WEEK STARTING 28 MAC 2022)
PORTFOLIO THEORY AND THE CAPITAL ASSET PRICING MODEL
(CHAPTER 8)

associated with finding the information needed. This applies not only to the
equity risk premium and the risk-free rate of return, but also to locating
appropriate proxy companies with business operations similar to the proposed
investment project. Most companies have a range of business operations they
undertake and so their equity betas do not reflect only the desired level and
type of business risk.

From a theoretical point of view, the assumptions underlying the CAPM can
be criticised as unrealistic in the real world. For example, the CAPM assumes
a perfect capital market, when in reality capital markets are only semi-strong
form efficient at best. The CAPM assumes that all investors have diversified
portfolios, so that rewards are only required for accepting systematic risk,
when in fact this may not be true. However, there is no practical replacement
for the CAPM at the present time. / APT – Arbitrage Pricing Model

9|Page