Question

Sagitta is a large fashion retailer that opened stores in India and China three years ago. This
has proved to be less successful than expected and so the directors of the company have decided
to withdraw from the overseas market and to concentrate on the home market. To raise the
finance necessary to close the overseas stores, the directors have also decided to make a one-
for-five rights issue at a discount of 30% on the current market value. The most recent income
statement of the business is as follows.

$m
Sales 1,400.00
Net Profit before interest and tax 52.0
Interest payable 24.0
Net profit before taxation 28.0
Company tax 7.0
Net Profit after taxation 21.0
Ordinary dividends payable 14.0
Accumulated profit 7.0

The capital and reserves of the business as at year end are as follows
$m
$0.25 ordinary shares 60.0
Revaluation reserve 140.0
Accumulated profits 320.0
520.0

The shares of the business are currently traded on the Stock Exchange at a P/E ratio of 16 times.
An investor owning 10,000 ordinary shares in the business has received information of the
forthcoming rights issue but cannot decide whether to take up the rights issue, sell the rights or
allow the rights offer to lapse.
Required
a) Calculate the theoretical ex-rights price of an ordinary share in Sagitta.
b) Calculate the price at which the rights in Sagitta are likely to be traded.
c) Evaluate each of the options available to the investor with 10,000 ordinary shares.
d) Discuss, from the viewpoint of the business, how critical the pricing of a rights issue
is likely to be

ZIPPORAH MBEWE

Assume that it is now 1 January 2007. On 1 January 2008, Zipporah intends to deposit K1,
000 into a savings account at one of the local commercial banks paying an 8% interest rate.

Required:

a. Assuming that the bank compounds interest annually, how much will Zipporah
have in her savings account on 1 January 2011?
b. What would Zipporah’s 1 January 2011 balance be if the bank used quarterly
compounding rather than annual compounding?
c. Suppose Zipporah deposited the K1, 000 in 4 payments of K250 each on 1
January 2008, 2009, 2010 and 2011. How much would she have in her savings
account on 1 January 2011, based on 8% annual compounding?
d. Suppose Zipporah deposited 4 equal payments in her savings account on 1
January 2008, 2009, 2010 and 2011. How large would each of her payments have
to be for Zipporah to obtain the same ending balance as the one calculated in part
(a) above?
Solution
a. K1, 000 is being compounded for three years so Zipporah’s balance on 1 January
2011 is calculated to be K1, 259.71. This is arrived at as follows:

FV = PV (1+i) t
= K1, 000 (1+ 0.08) 3 = K1, 259.71

b. The effective annual interest rate for 8%, compounded quarterly is calculated as:
EAR = (1 + 0.08/4) 4 – 1.0
= (1.02) 4 – 1.0 = 0.0824 = 8.24%.
 Therefore, the FV = K1, 000 (1.0824) 3 = K1, 000 (1.2681) = K1, 268.10.

c. As you work this problem, keep in mind that the tables assume that payments are
made at the end of each period. Therefore, you must solve this problem by
finding the future value of an annuity of K250 for years at 8%.

PMT (FVIFA k, n) = K250 (4.5061) = K1, 126.53

d. FV = K1, 259.71; i = 8%; t=4.

PMT (FVIFA 8%, 4 years) = FV

PMT (4.5061) = K1, 259.71
PMT = K1, 259.71 / 4.5061 = K279.56

Therefore, Zipporah would have to make 4 payments of K279.56 each to have a

balance of K1, 259.71 on 1 January 2011.

Question

Nalukui Plc has two separate portfolios of shares in diverse industries. The company is
proposing to liquidate one of these two portfolio investments in order to raise funds for a new
venture, but the directors are unsure about which one to hold and which one to liquidate.

Portfolio 1

Share Beta of share Actual Return Amount Invested

(%) (ZK’ million)
Mumba Plc 1.2 14 8.7
Moses Plc 0 6 6.8
Malama Plc 0.8 11 4.4
Bunda Plc 1.5 15 5.1
Portfolio 2
Share Beta of share Actual Return Amount Invested
(%) (ZK’ million)
Nkandu Plc 0.9 12 7
Bange Plc 0.3 9 3.6
Chewe Plc 1.7 19 8.5
Mukuka Plc 0.1 8 5.9

Vanessa Mulenga, the Finance Director of the company wishes to assess which portfolio has
performed better, on the basis of the capital asset pricing model (CAPM). At a meeting,
Nalukui’s Managing Director suggests that portfolio theory would provide the most
appropriate and useful measure of risk for evaluating the performance of the two portfolios.
The Chairman says that she does not understand what the argument is about since both CAPM,
and the portfolio theory on which it is based, provide the same measure of risk.

The Bank of Zambia treasury bills rate of return is 5.5% and the market risk premium in the
financial market is currently estimated at 8%.

Required:

(a) Explain the principle of portfolio diversification, and its relevance in developing the capital
asset pricing model. What does the ‘beta’ of a share represent, and how is it determined?

(b) Discuss the Chairman’s view that CAPM and portfolio theory provide the same measure of
risk.

(c) Using the capital asset pricing model identify which of the two portfolios has performed
better, and comment briefly on the validity of your conclusions.

ANSWER
(a) Reduction of portfolio risk

Combining stocks in a portfolio results in reduction of portfolio risk. After the addition of about
15 to 20 stocks to a portfolio, the risk reduction effect begins to taper off. The degree of
correlation between the returns on the different investments in the portfolio affects the amount
of risk reduction. The greatest risk reduction occurs when correlation is negative. Most
securities tend to be positively correlated, limiting the scope for risk reduction.

The total risk of a security held in isolation is more than that of the same security held as part
of a portfolio - the risk that is removed through portfolio diversification is the security’s specific
risk, caused by random events affecting the company. The effects of such random events are
reduced or eliminated by diversification, so specific risk is also called diversifiable risk. The
technical term for this risk is unsystematic risk.

Systematic risk affects all the securities in the market, and is associated with factors such as
economic conditions, political events and general market sentiment. Systematic risk is also
called market risk or undiversifiable risk. Diversified investors are concerned about the
systematic risk of a security – not the specific risk, which can be diversified away.

The ‘market portfolio’ refers to a hypothetical portfolio of all the shares in the market, weighted
according to market capitalisation This is the most efficient portfolio, containing only
systematic risk – all unsystematic risk has been diversified away.

The beta of a share is the slope of a regression line of the historical returns on the share against
the returns on the market portfolio. It therefore measures the change in the share’s return that
is ‘explained’ by change in the return on the market portfolio, and thus provides a measure of
the share’s systematic risk. Given the return on the market portfolio and the risk-free return,
the expected return on any share can be estimated with reference to the share’s beta.

(b) Measures of risk

Portfolio theory uses the standard deviation of a portfolio’s return to provide a measure of the
total risk of the portfolio – both systematic and unsystematic risk. CAPM uses the beta to
provide a measure of the systematic risk only. Portfolio theory and CAPM would only give the
same portfolio risk measure if the portfolio were so well diversified that all unsystematic risk
has been eliminated.

(c) CAPM

Using CAPM to assess portfolio performance the weighted average systematic risk of each
portfolio can be calculated and, using CAPM, the expected return of each portfolio can be
estimated.

Portfolio 1:

Portfolio beta = (1.2 x 0.348) + (0 x 0.272) + (0.8 x 0.176) + (1.5 x 0.204)

= 0.8644
Expected return = 5.5 + (8 x 0.8644)
= 12.42%
The actual return of the portfolio over the last year was:
(14 x 8.7/25) + (6 x 6.8/25) + (11 x 4.4/25) + (15 x 5.1/25)
= 11.50%
Portfolio 1 has therefore under-performed.

Portfolio 2:

Portfolio beta = (0.9 x 0.280) + (0.3 x 0.144) + (1.7 x 0.340) + (0.1 x 0.236)
= 0.8968
Expected return = 5.5 + (8 x 0.8968)
= 12.67%
The actual return of the portfolio over the last year was:
(12 x 7/25) + (9 x 3.6/25) + (19 x 8.5/25) + (8 x 5.9/25)
= 13.00%

Therefore Portfolio 2 has over-performed. Using CAPM, it is possible to recommend Portfolio

2, which has a positive abnormal return. However, a portfolio of only four investments cannot
be said to be well diversified, so Maxima would be exposed to unsystematic risk as well.
Alternative portfolios with a greater degree of diversification should be considered.

The perfect market assumptions on which the CAPM is based are limitations that should also
be kept in mind when drawing conclusions. Various researchers have questioned other aspects
of CAPM, notably:

▪ Betas calculated on the basis of historical returns do not necessarily remain stable.
▪ CAPM oversimplifies reality by relating expected return to a single factor, i.e. the return
on the market portfolio; and
▪ Indices used as market proxies in CAPM calculations do not exactly represent the whole
market.