Corporate Finance – BA303

Tutorial 5 (Answers)
Corporate Finance – BA303
1. Mystery Enterprises has a proposal costing £800. Using a 10 per cent cost of capital,
compute the expected NPV, standard deviation and coefficient of variation, assuming
independent interperiod cash flows.

Answer:

2. Which type of risk do the following describe:

a. Risks associated with increasing the level of borrowing?
b. The variability in the firm’s operating profits?
c. Variability in the cash flows of a proposed capital investment?
d. Variability in shareholders’ returns?

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 Corporate Finance – BA303

Answer :
(1) Financial risk; (2) Business risk; (3) Project risk; (4) Portfolio or market risk.

3. Determine the risk-minimizing portfolios for the following two asset portfolios.

Answer :
(i) σp = [wA2σA2 + wB2σB2 + 2wAwBrABσAσB]0.5 = [wA2(0.0009) + wB2(0.0049) + 0.0042
wAwB]0.5
(ii) σp = [wA2σA2 + wB2σB2 + 2wAwBrABσAσB]0.5 = [wA2(0.0144) + wB2(0.0036) + 0.0072
wAwB]0.5
(iii) σp = [wA2σA2 + wB2σB2 + 2wAwBrABσAσB]0.5 = [wA2(0.0225) + wB2(0.0001) – 0.0015
wAwB]0.5
(iv) σp = [wA2σA2 + wB2σB2 + 2wAwBrABσAσB]0.5 = [wA2(0.0225) + wB2(0.0001)]0.5

4. Tomb-zapper plc manufactures computer video games. It is considering whether to expand

production at its existing site in ‘Silicon Glen’ in Scotland, or to start production in a
‘greenfield site’ in China, where labour costs are considerably lower than in Europe. The
IRRs for each project depend on average rates of growth in the world economy over the ten-
year life span of the project. These are expected to be:

Tomb-zapper wants to exploit the less than perfect correlation between the returns from the two
projects, without over-committing itself to the China investment.
Required
(a) What is the expected return and standard deviation of return for each separate project?

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(b) Determine the expected return and standard deviation of an expansion programme that
involves 25 per cent of available funds in China and 75 per cent in the Scottish location.
Answer :

5. The management of Gawain plc is evaluating 2 projects whose returns depend on the future
state of the economy as shown in the following table:

Probability IRRA(%) IRRB(%)

0.3 27 35
0.4 18 15
0.3 5 20

The project (or projects) accepted would double the size of Gawain.

Required:
Explain how a portfolio should be constructed to produce an expected return of 20%.
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Answer :
Gawain plc
Project A
Expected return = (0.3 × 0.27) + (0.4 × 0.18) + (0.3 × 0.05)
= 0.081 + 0.072 + 0.015
= 0.168, that is, 16.8%
Project B
Expected return = (0.3 × 0.35) + (0.4 × 0.15) + (0.3 × 0.20)
= 0.105 + 0.06 + 0.06
= 0.225, that is, 22.5%

To achieve an expected return of 20%

Let α be % weighting in A
(1 − α) = % weighting in B
0.20 = α E(RA) + (1 − α) E(RB)
0.20 = α (0.168) + (1 − α) (0.225)
0.20 = 0.168α + 0.225 − 0.225α
Hence,
-0.025 = -0.057α
α = 0.025/0.057 = 0.44
Therefore, 44% of the portfolio should be invested in Project A and 56% in Project B.

6. Rahman Berhad’s ordinary shares have an expected return of 25 per cent and a coefficient
of variation of 2.0. What is the variance of Rahman Berhad’s ordinary shares returns ?

Answer :
Since the coefficient of variation = CVi = σRi /E(Ri), substituting in the coefficient of
variation and E(Ri) allows us to solve for σ2return as follows:
2.0 = σRi/0.25
σRi = 0.5
σ2Ri= (0.5)2 = 0.25

7. John is watching an old game show on rerun television called Let’s Make a Deal in which
you have to choose a prize behind one of two curtains. One of the curtains will yield a gag
prize worth $150 and the other will give a car worth $7,200. The game show has placed a
subliminal message on the curtain containing the gag prize, which makes the probability
of choosing the gag prize equal to 75 per cent. What is the expected value of the selection
and what is the standard deviation of that selection ?
Answer :
E(prize) = 0 .75($150) + (0.25) ($7,200) = $1 912.50
σ2prize = 0.75($150 – $1 912.50)2+ (0.25) ($7 200 – $1 912.50)2
= $9 319 218.75
σprize = ($9 319 218.75)1/2 = $3052.74

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8. Shares A, B and C have expected returns of 15 per cent, 15 per cent and 12 per cent,
respectively, while their standard deviations are 45 per cent, 30 per cent and 30 per
cent, respectively. If you were considering the purchase of each of these shares as
the only holding in your portfolio, then which share should you choose ?
Answer :
Since the holding will be made in a completely undiversified portfolio, then we can
calculate the risk per unit of return for each share, the coefficient of variation and
choose the share with the lowest value.
CV(RA) = 0.45/0.15 = 3.0
CV(RB) = 0.30/0.15 = 2.0
CV(RC) = 0.30/0.12 = 2.5 ===> Choose B
9. Success plc is an undiversified and ungeared company operating in the cardboard
packaging industry. The Beta coefficient of its ordinary shares is 1.05. It now contemplates
diversification into making plastic containers. After evaluation of the proposed investment,
it considers that the expected cash flows can be described by the following probability
distribution:

State of economy Probability Internal rate of return

(%)
Recession 0.2 -5
No growth 0.3 8
Steady growth 0.3 12
Rapid growth 0.2 30

The overall risk (standard deviation) of parent company returns is 20% and the risk of the market
return is 12%. The risk-free rate is 5% and the FTSE 100 Index is expected to offer an overall
return of 10% per annum in the foreseeable future.

The new project will increase the value of Success plc’s assets by 33%.

Required:
(a) Calculate the risk-return characteristics of Success plc’s proposed diversification.
(b) It is believed that the plastic cartons activity has a covariance value of 40 with the
company’s existing activity.
(i) Calculate the total risk of the company after undertaking the diversification.
(ii) Calculate the new Beta value for Success plc, given that the diversification lowers
its overall covariance with the market portfolio to 120.
(iii) Deduce the Beta value for the new activity.
(iv) What appears to be the required return on this new activity ?
(c) Discuss the desirability, from the shareholders’ point of view, of the proposed
diversification.

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Answers:
Success plc
(a) Expected IRR = (0.2 × −5%) + (0.3 × 8%) + (0.3 × 12%) + (0.2 × 30%)
= (−1% + 2.4% + 3.6% + 6%)
= 11%
Outcome Probability Expected Deviation Squared Weighted
Return Deviation by
Probability
-5 0.2 11 -16 256 51.2

8 0.3 11 -3 9 2.7

12 0.3 11 +1 1 0.3

30 0.2 11 +19 361 72.2

Variance = 126.4

Std 11.24%
Deviation=

(b)
(i) Ơp = [(0.75)2(20)2 + (0.25)2(11.24)2 + 2(0.75)(0.25)(40)]0.5 = (225 + 7.9 + 15)0.5
= (247.9)0.5 = 15.75
That is, total risk = 15.75%, reduced from 20%.
(ii) βj = covjm / σ2m = 120/122 = 120/144 = 0.83
(iii) New Beta = (¾ × existing Beta) + (¼ × Beta of project)
0.83 = (¾ × 1.05) + (¼ × Beta of project)
Beta of project = [(0.83 – 0.7875)/0.25] = 0.17
(iv) ER = 5% + 0.17 [10% − 5%] = 5.85%

(c) The new project lowers the total risk and the overall company Beta. This might please a
highly risk-averse shareholder, but as investors are able to achieve their desired risk/return
combinations by portfolio formation, some may resent the company’s interference with
their preferences.