zzFINM 2412 Financial Management for Business

Tutorial 9 Answers

Question 1
The risk-free rate is 7% p.a. The expected return on the market portfolio is 12% p.a., and the variance

of this return is 0.09.

You are examining two stocks: A and B. The standard deviations of the returns on Stocks A and B are
50% p.a. and 20% p.a. respectively. The correlation between each stock and the market is:
.

a. Calculate the beta of each stock.

b. Calculate the expected return of each stock.

c. You construct a portfolio with 60% of your money in Stock A and 40% in Stock B. What is the
beta of this portfolio? What is the expected return of this portfolio?

Hint: The beta of Stock A is equal to its covariance with the market divided by the variance of the
market:

Hint: Covariance is a function of the standard deviation of each asset and the correlation between
them.

(a)

We know that a stock’s beta is closely related to its covariance with the market:

cov ( r A ,r m )
β A=
var ( r m )

However, this question does not provide the covariance between the stock and the market;
rather, it provides the correlation between the stock and the market. That is fine, so long as we
know the following formula:

cov ( r A ,r m )=ρ A ,m σ A σ m

Thus, we can re-write the beta formula using correlation:

ρ A ,m σ A σ m ρ A , m σ A (0.90)( 0.50)
β A= = = =1.5
σ
2
m
σm √ 0.09

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and

ρ B , m σ B (0.60)(0.20)
βB= = =0.4
σm √ 0.09
(b)

The CAPM is a model that dictates the expected return on a stock. Applying CAPM is easy since
we have already calculated betas in (a):

E ( r A )=r f + β A [ E ( r m )−r f ]¿ 0.07+1.5 ( 0.12−0.07 )¿ 14.5 % p . a .

E ( r B )=r f + β B [ E ( r m )−r f ] ¿ 0.07+ 0.4 ( 0.12−0.07 )¿ 9 % p . a .

(c)

There are several ways to answer this question. First, if we know the beta of the portfolio, we
could just plug it into CAPM. Note that the beta of a portfolio is simply the weighted-average of
the betas of the stocks in that portfolio:

β p=w A β A + wB β B¿ 0.6 ( 1.5 ) +0.4 ( 0.4 )¿ 1.06

Plugging this into CAPM, the expected return of this portfolio is:

E ( r p ) =r f + β p [ E ( r m )−r f ] ¿ 0.07+1.06 ( 0.12−0.07 )¿ 12.3 % p . a .

Alternatively, the expected return on a portfolio is just a weighted-average of the expected return
on each stock in that portfolio. Thus, we could also compute the expected return of this portfolio
as:

E ( r p ) =w A E ( r A ) + w B E ( r B )¿ 0.6 ( 0.145 )+ 0.4 ( 0.09 ) ¿ 12.3 % p . a .

Question 2
In the following table, X, Y, and Z refer to stocks, while M refers to the market portfolio. The
following partially complete information is available:

Standard Expected Covariance between

Deviation Return Stock and Market
X 0.1 ? 0.01
Y 0.2 ? 0.025
Z ? 0.216 0.052

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 M 0.1414 0.120 n/a

The correlation between Stocks X and Y is 0.60.

Required

a. Calculate the betas of Stocks X and Y.

b. Calculate the beta of a new portfolio comprising 80% in X and 20% in Y.

c. What is the risk-free rate of return?

d. What is the expected return on the new portfolio in (b)?

A question like this provides some information and withholds other pieces of information.
Answering it is a matter of asking ‘what am I looking to solve for?’ and ‘what information have I
been given?’

(a)

Use the definition of beta:

cov ( r X , r m ) 0.01
β X= 2
= =0.5
σ m ( 0.1414 )2

cov ( r Y , r m ) 0.025
βY = 2
= =1.25
σ m ( 0.1414 )2

(b)

The beta of a portfolio is a weighted average of the betas of each stock:

β p=w X β X + wY β Y ¿ 0.80 ( 0.5 )+ 0.20 (1.25 )¿ 0.65

(c)

This is an example of asking ‘what am I looking for?’ Answer, the risk-free rate. So what formulas
do I know that include the risk-free rate. Answer, the CAPM. We cannot use the information
about Stocks X or Y since their expected returns are not given. However, the expected return on
stock Z is given. Use the CAPM and information about Stock Z:

cov ( r z , r m ) 0.052
βz= 2
= =2.6
σ m ( 0.1414 )2

E ( r z )=r f + β z [ E ( r m ) −r f ]0.216=r f +2.6 ( 0.12−r f ) r f =6 % p .a .

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(d)

Use the CAPM:

E ( r p ) =r f + β p [ E ( r m )−r f ] ¿ 0.06+ 0.65 ( 0.12−0.06 )¿ 9.9 % p . a .

Question 3
Consider a CAPM economy in which the risk-free rate is 4%, the expected return on the market
portfolio is 11% and the standard deviation of the market portfolio is 15%.

a. What is the most efficient way of investing if you require a return of 10% p.a.? In this case,
what risk would you be bearing?

b. How would you invest to earn the highest possible expected return while limiting your risk to
a standard deviation of 12%?

(a)
The most efficient way of investing is to adopt a position somewhere on the CML. Hence, we have:

E [ r p ] =r f +
[ E [ r M ] −r f
σM ] σp

0.10=0.04+
[ 0.11−0.04
0.15
σp
]
which implies that σ p=12.86 % .

To find out how this portfolio is constructed, we solve:

E [ r p ] = ( 1−w M ) r f +w M E [ r M ]

E [ r p ] =r f + w M ( E [ r M ]−r f )

0.10=0.04+ w M (0.11−0.04)
w M =0.86

which implies that we would invest 86% of our money into the market portfolio and the rest into
government bonds.

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(b)

Again use the CML:

E [ r p ] =r f +
[ E [ r M ] −r f
σM ] σp

¿ 0.04 +
[ 0.11−0.04
0.15
0.12=9.6 %
]
To find out how this portfolio is constructed, we solve:

E [ r p ] = ( 1−w M ) r f +w M E [ r M ]

E [ r p ] =r f + w M ( E [ r M ]−r f )

0.096=0.04+ w M (0.11−0.04)
w M =0.80

which implies that we would invest 80% of our money into the market portfolio and the rest into
government bonds.

Question 4
Suppose a company uses only debt and internal equity to finance its capital budget and uses CAPM to
compute its cost of equity. Company estimates that its WACC is 12%. The capital structure is 75%
debt and 25% internal equity. Before tax cost of debt is 12.5% and tax rate is 20%. Risk free rate is
6% and market risk premium is 8%. What is the beta of the company?

After tax cost of debt:

12.5% (1 – 20%) = 10%

WACC = 12%
75% * Cost of Debt + 25% * Cost of Equity = 12%
75% * 10% + 25% * Cost of Equity = 12%
Cost of Equity = 18%

18% = rf + beta *MRP

Beta = (18%-6%)/8% = 1.5