Financial Management 2018

Risk and Return Analysis: Portfolio Theory and CAPM

Q1. The month end prices for two stocks and the market are given for six months.

Month Pak Tobacco Bank Al-Falah KSE-100

January 108.01 13.36 9,614.19
February 109 12.43 9,657.79
March 116 12.41 10,178.43
April 114.76 11.4 10,428.12
May 102.5 8.93 9,326.42
June 104.01 9.46 9,721.91

a. Calculate the monthly returns for each stock and market.

b. Calculate the average monthly return and standard deviation for each
stock and market.
c. Calculate the correlation between the two stocks and comment on the
result.
d. Compute the beta for the two stocks, and comment on the results.

Q2. Assume that you are considering selecting assets from among the following four
candidates:
Market Asset 1 Asset 2 Asset 3
condition
return probability return probability Return Probability
Good 16 ¼ 4 1/4 20 ¼
Average 12 ½ 6 1/2 14 1/2
Poor 8 ¼ 8 1/4 8 1/4

a. Solve for the expected return and standard deviation of return for each
separate investment.
b. Solve for the correlation coefficient and the covariance between each pair
of investments.
c. Solve for the expected return and variance of the portfolio comprising 50%
of asset 1 and 50% of asset 2.
d. On the same graph plot the expected return and standard deviation for all
possible combinations of securities 1 and 2.
e. For securities 1 and 2 find the composition, standard deviation, and
expected return of that portfolio that has minimum risk.
f. Assuming that investors prefer more to less and are risk averse, indicate in
red those sections of the diagram in part ‘d’ that are efficient.

Q3. Mean annual returns, standard deviations and correlation (using data for 1998-
2012) for Siemens and Shell are given in the following table:

Page 1 of 8
 Financial Management 2018

Siemens Shell
Mean Annual Return 21.88 7.2
Standard Deviation 35.08 46.49
Correlation 0.5711

What is the combination of the above two stocks that yields the minimum risk
and what is that risk? Also compute the return for the minimum-risk portfolio.

Q4. For the 2 securities shown plot all combinations of the 2 securities in Risk return
space. Assume p = 1, -1, 0. For each correlation coefficient what is the
combination that yields the minimum risk and what is that risk?

Expected Return Standard Deviation

Security 1 10% 5%
Security 2 4 2%

Q5. Assume there are three major classes of risky securities available:

Security Total Standard Correlation with

Market Deviation A B C
A $ 10,000 20% 1.0
B $ 6,000 30% 0.30 1.0
C $ 4,000 15% 0.30 0.30 1.0

a. What is the standard deviation of the total market portfolio?

b. If RF is 8% and MRP is 5% what are the CML and SML equations?
c. If the beta of the security C is 1.2, what should be the expected return on
the security to qualify for a purchase?

Page 2 of 8
 Financial Management 2018
Cost of Capital

Q1. The Sprouts-N-Steel Company has two divisions: Health Foods and Specialty
Metals. Each division employs debt equal to 30% and preferred stock equal to 10% of
its total requirement, with equity capital used for the remainder. The current borrowing
rate is 15%, and the company’s tax rate is 40%. Presently preferred stock can be sold
yielding 13%.
Sprout-N-Steel wishes to establish a minimum return standard for each division based
on the risk of that division. The company has thought about using the CAPM model in
this regard. It has identified two samples of companies, with model value betas of 0.90
for health foods and 1.30 for specialty metals. The risk-free rate is presently 12% and
the expected return on the portfolio is 17%. What weighted average required returns on
the investment would you recommend for the two divisions?

Q2. Zapata Enterprises is financed by two sources of funds: bonds and common stock.
The capital structure consists of B dollar of bonds and S dollar of stock, where the
amounts represent the market values. Assume that B is $3 million and S is $7 million.
The bonds have a 14 % yield to maturity, and the stock is expected to pay $500,000 in
dividends this year. The growth rate of dividends has been 11% and is expected to
continue at the same rate. Find the cost of capital the corporation tax rate on income is
40%.

Q3. Addison Glass Company has a $1000 par value bond outstanding with 25 Years to
maturity. The bond carries an annual interest payment of $88 and is currently selling for
$925. Addison is in a 25% tax bracket. The firm wishes to know what the after-tax cost
of a new bond issue is likely to be. The yield to maturity on the new bond will be 0.25%
higher than the YTM on the old issue. What will be the after-tax cost of new debt?

Q4. Burger Queen can sell preferred stock for $70 with an estimated floatation cost of
$2.50. The preferred stock is anticipated to pay $6 per share in dividends. Compute the
after-tax cost of preferred stock.

Q5. Compute the cost of Retained Earnings and the cost of new equity under each
case.
a. D1= $4.20, P0 =$55, g=5%, F= $3.80
b. Earnings at the end of period 1= $8, Payout ratio= 25%, P0= $32, g= 5%, F=
$1
c. Dividend at the start of the period 1= $3, P0= $60, g=9%, F= $3.50
Q6. Business has been good for Keystone Controls Systems, as indicated by the four-
year growth in EPS. The Earnings have been grown from $1.00 to $1.63
a. Determine the compound annual rate of growth in earnings.
Page 3 of 8
 Financial Management 2018
b. Project the earnings for the next year.
c. If the dividend payout is 40% and price of the stock is $50, compute K.
Assume the growth in dividends will remain constant in future.
d. If the floatation cost is $3.75, compute the cost of new common stock.

Q7. Given the following information, Calculate the WACC:

% of Capital Structure
Debt 40%
Preferred Stock 10
Common Equity 50
Additional Information
Bond Coupon rate 12%
Bond Yield 10%
Dividend expected, Common $3.00

Dividend, Preferred $9.20

Price, Common $60
Price, Preferred $99

Floatation Cost, Preferred $4

Corporate growth rate 9%
Corporate tax rate 30%

Q8. The Nolan Corporation finds it is necessary to determine its marginal cost of capital.
Nolan’s current capital structure calls for the 45% debt, 15% preferred stocks, and 40%
common equity. Initially the common equity will be in the form of retained earnings and
then the new common stock. The costs of various sources of financing are as follows:
Debt: 5.6%; Preferred Stock: 9%; Retained Earnings: 12%; and new common stocks:
13.2%

a. What is the initial WACC?

b. If the firm has $12 million in retained earnings, at what size of capital
structure will the firm run out of retained earnings? What will the marginal
cost of capital be immediately after the point?
c. The 5.6% cost of debt applies only the first $18 million of debt. After that,
the cost will be 7.2%. At what size of capital structure will there be a
change in the cost of debt? What will the marginal cost of capital be
immediately after that point?

Page 4 of 8
 Financial Management 2018
Stock Valuation

Q1. Here is some financial and stock market information about a hypothetical firm called
Data Control.

Total equity (common) 1,600 million

Net income 240 million
Dividends paid 144 million
Common shares outstanding 40 million
Price per share 47.70
Risk-free rate 9%
Expected return on the market 14%
Estimated beta for the firm’s 1.20
stock

a. Calculate the required return on Data Control using the security market
line.
b. What is the fair market price of Data Control, assuming the relationships
shown in the income statement and balance sheet items will remain
constant over the years. Would you buy the stock?
c. Assume that Data Control’s beta is really 1.0. Now what should the
stock sell for?

Q2. You have gathered the following data on five stocks that are assumed to have
constant dividend growth. In addition, data are given on a sixth stock that is not
expected to have a constant growth.

Stock 1 2 3 4 5
Price 111.11 62.50 125.00 31.25 11.76
D1 4 3 5 1 .40
G 8% 8% 10% 12% 13%
beta 0.6 0.8 1 1.2 1.4

Risk-free rate 8%
STOCK 6
Last dividend (just paid) 0.20
Growth yr 1-5 20%
Growth yr 6 plus 5%
Beta 1.60

a. Calculate the expected returns for stock 1-5.

b. What should the stock 6 be selling for today?

Page 5 of 8
 Financial Management 2018

Q3. The common shares of GEB Resources are currently being traded at $35 per
share. A dividend of $2 was just paid. You expect this dividend per share to grow at a
constant rate of 6%. What must your required return be if you believe that the price
of $35 is reasonable?

Page 6 of 8
Financial Management 2018

Page 7 of 8
 Financial Management 2018
SAMPLE QUIZ
Topic: Cost of Capital

1. Accounts payable and accruals are sources of funding for the firm; therefore, these
sources should also be included in the calculation of WACC.
a. True
b. False

Aries Ltd wishes to raise finance for meeting its investment plans. It has $250,000 in the
form of retained earnings available for investment purposes. The following are the
further details:
 Debt-equity mix of 30:70
 Cost of debt:10%
 Current EPS(at time t=0): $4
 Dividend payout: 50%
 Current market price per share(at time=0): $44
 Constant growth rate: 5%
 Floatation cost per share: $4
 Tax rate: 35%

2. After tax cost of debt for the company is:

a. 3.5%
b. 6.5%
c. 10%

3. Cost of retained earnings for the firm is:

a. 9.55%
b. 9.77%
c. 10%
d. 10.25%

4. Cost of new equity for the firm is:

a. 9.55%
b. 9.77%
c. 10%
d. 10.25%

5. The firm has $10 million in its retained earnings. Compute the initial COC for the firm.
a. 9.55%
b. 10%
c. 10.25%
d. Some other amount

Page 8 of 8