FIN223: Tutorial Questions Week 6

Chapter 5: Problems P 5.16, P5.17, P5.18. P5.19, P5.20 & P5.21 and other problems

Qn 1. A)
P5.16: You are evaluating two possible stock investments, Leverage Co. and Value Corp.
Leverage Co. has an expected return of 10% and a beta of 1.4. Value Corp. has an expected
return of 10% and a beta of 0.9. Based only on this data, which stock should you buy and why?
Answer:
You should buy the stock of Value Corp. because it provides the same expected return at lower
risk (beta) as Leverage Co., has lower risk (a lower beta).

Qn 1. B)
P5.17 Referring to Problem 5.16, if you expect a significant market slump, would your decision
be altered? Explain.
Answer:
Your decision will not be altered because the stock of Leverage Co. is likely to fall more sharply
than that of Value Corp. when the market slumps.

Qn 1. C)
P5.18 A security has a beta of 1.2. Is this security more or less risky than the market? Explain.
Assess the impact on the required return of this security in each of the following cases.
a. The market return increases by 15%.
b. The market return decreases by 8%.
c. The market return remains unchanged.
Answers:
A beta of 1.2 suggests that this security is 20% riskier than the market, meaning that the stock has 20%
more systematic risk than the overall market does. When the market moves, this stock will, on
average, move even more.

a. If the market’s return increases 15%, the security’s expected return should increase by 1.2(15%)
= 18%.

b. If the market’s return decreases 8%, the security’s expected return should decrease by 1.2(8%) =
9.6%.
 c. If the market’s return remains constant, the security’s expected return should be unchanged. The
security’s expected risk premium is 20% greater than the market’s expected risk premium.

Qn 2. A)
P5.19 Assume the betas for securities A, B, and C are as shown here
Security Beta
A 1.4
B 0.8
C -0.9

a. Calculate the change in return for each security if the market experiences an increase in its rate
of return of 13.2% over the next period.
b. Calculate the change in return for each security if the market experiences a decrease in its rate
of return of 10.8% over the next period.
c. Rank and discuss the relative risk of each security on the basis of your findings. Which
security might perform best during an economic downturn? Explain
Answers:
a. If the market return increases by 13.2%, the table below shows the extent to which each security’s
return will change in response:
Security Beta Change in Change in
rm ri
A 1.4 13.2% 18.5%
B 0.8 13.2% 10.6%
C –0.9 13.2% –11.9%

b.
Security Beta Change in Change in
rm ri
A 1.4 –10.8% –15.1%
B 0.8 –10.8% –8.6%
C –0.9 –10.8% 9.7%
 c. Ranking: Security B : 1st rank since low beta. Security C: 2nd rank, Security A is the thrid rank
since it has higer beta value.

Security A is the most risky security in the sense that it has the highest beta.Security C’s negative
beta means that its returns are negatively correlated with the market, making it the least risky
security. Because Security C performs best when most other securities are performing poorly
(i.e., C does well when the market does poorly), it acts like a kind of insurance policy for a stock
portfolio. Adding C to a portfolio with a positive beta would therefore reduce the portfolio’s
overall risk. A portfolio comprised of 50% A and 50% C, for example, would have a beta of
only 0.5(1.4) + 0.5(–0.9) = 0.25.

Qn 2. B)
P5.20 Referring to Problem 5.19, assume you have a portfolio with $20,000 invested in each of
investments A, B, and C. What is your portfolio beta?
Answer:
Because each investment has an equal weight, the portfolio beta is simply 1/3(1.4) + 1/3(0.8) +
1/3(–.9) = 0.43.

Qn 2. c)
P5.21 Referring to Problem 5.20, using the portfolio beta, what would you expect the value of
your portfolio to be if the market rallied 20%? Declined 20%?
Answer:
If the market rallied 20%, the portfolio would be expected to rise by 0.43(20%) = 8.6%. The $60,000
portfolio would then have a value of $60,000(1.086) = $65,160.

If the market declined 20%, the portfolio would be expected to fall by 0.43(20%) = 8.6%. The $60,000
portfolio would then have a value of $60,000(1 – 0.086) = $54,840.

Qn 3. A)
The following are the returns and risk level of four different stocks in Peter’s portfolio. You are
required to rank them according to their efficiency.
Stock Return Risk (Beta) Rank
A 14.4% 1.2
B 16.5% 1.65
C 11.7% 0.9
D 12.0% 1.5
Answer:
Stock Return Risk (Beta) Return/Risk Rank
A 14.4% 1.2 12 II
B 16.5% 1.65 10 III
C 11.7% 0.9 13 I
D 12.0% 1.5 8 IV

Qn 3. B)
Miss Jhansi has the following stocks in her portfolio, You are required to compute the portfolio
return.
Stock Value Return
A 300 10%
B 450 12%
C 1050 15%
D 1200 20%

Answer:
Stock Value Return Weight of each Weighted return
stock
A 300 10% 10% 1%
B 450 12% 15% 1.8%
C 1050 15% 35% 5.25%
D 1200 20% 40% 8%
Total 3000 100% 16.05%

Qn 3. C)
A portfolio consists of Debt and Equity as detailed below.
Stock Value $ Return Standard Correlation
Deviation between debt
and equity
Debt 300 10% 0.7
0.8
Equity 700 15% 1.1
You are required to compute-
i) Portfolio return ii) Portfolio risk.
Answers:
i) Total portfolio size $1,000

Weight of Debt = 300/(300+700) = 0.3

Weight of equity = 700/(300+700) = 0.7
Portfolio return = (0.3 x 10%) + (0.7 x 15%) = 13.5%

ii) Portfolio risk

Variance = [(0.3)2 x (0.7)2] + [(0.7)2 x (1.1)2] +

[2 *(0.3) (0.7) (0.7) (1.1) (0.8)] = 0.89572

SD = SQRT of 0.89572 = 0.9464

Qn 3. D)
A portfolio consists of Debt and Equity as detailed below.
Stock Value Return Standard Correlation
Deviation between debt
and equity
Debt 3200 12% 0.6
0.9
Equity 4800 18% 1.2

You are required to compute-

i) Portfolio return ii) Portfolio risk.
Answers:
i) Total portfolio size $8,000
ii)
Weight of Debt = 3200/ 8000 = 0.4
Weight of equity = 4800/8000 = 0.6

Portfolio return = (0.4 x 12%) + (0.6 x 18%) = 15.6%

 iii) Portfolio risk
Variance = [(0.4)2 x (0.6)2] + [(0.6)2 x (1.2)2] +

[2 *(0.4) (0.6) (0.6) (1.2) (0.9)] = 0.05760+ 0.51840+ 0.31104 = 0.88704

SD = SQRT of 0.88704 = 0.9418
Qn 4.
The following details are given in respect of three stocks. You are required to identify the
overvalued and undervalued stock. Which one you will buy or sell?
Risk-free rate is 4% and the market return rate is 10%

Stock Beta Forecasted return

A 1.5 15%
B 1.2 11.2%
C 0.8 8.2%

Answer:
Stock Rf Rm -Rf Beta Er Forecasted Buy/sell
return
A 4% 6% 1.5 13% 15% Under Buy
valued
B 4% 6% 1.2 11.2% 11.2% Correctly Buy
valued
C 4% 6% 0.8 8.8% 8.2% Over Sell
valued

Chapter 6 – Common Stocks

Qn 1
Royal Tulip Ltd furnished the following details pertaining to their current financial year.
Profit earned before tax $ 100 million.
Tax rate is 20%
Dividend paid $ 60 million.
Total number of equity shares outstanding 5 million
Current market price of one share $ 60
 You are required to compute i) EPS (Earning per share) and ii) DPS (Dividend per share)
iii)Dividend yield and iv) Dividend payout ratio
Answers:
i) EPS = (100 M x (1-0.2))/5 M = $16

ii) DPS = (60 M/5 M) = $12

iv) Dividend yield

($60 m/ 5m)
---------------- x 100 = 20%
$60
v) Dividend payout ratio = (60/80) x 100 = 75%

Qn 2:
A Dubai investor invested in Australian market.
When invested the market value of one share was A$ 26 and the exchange rate was 1 A$ to =
AED 2.5
After one year he received a dividend of A$ 2 and the market value of share was A$ 28 and
the exchange rate was 1 A$ = AED 2.4
Find the global return.
Answer:

Answer
Dividend A $ 2.00
Price at exit A $ 28.00
Exchange rate at exit 1 A $ = AED 2.40
 Price at entry A $ 26.00
Exchange rate at exit 1 A $ = AED 2.50

Global return

(28 + 2) x 2.40
= ---------------------- - 1 = 0.1077 or 10.77%
26 x 2.50
Qn 3:
Anjali, an US investor invested in Austrian market.
When invested the market value of one share was Euro 26 and the exchange rate was 1 Euro
to = USD 1.10
After one year she received a dividend of Euro 2.80 and the market value of share was Euro
28 and the exchange rate was 1 Euro = USD 0.90
Find the global return.
Answer
Dividend Euro 2.80
Price at exit Euro 28.00
Exchange rate at exit 1 Euro = USD 0.90

Price at entry 26.00

Exchange rate at exit 1 Euro = USD 1.10

Global return

= ([(2.80+28) x 0.90]/ [26x 1.10]) -1 = -0.0308 = -3.08%