Strategic Financial

Management

Portfolio Management

Extra Practice Questions

 Strategic Financial Management

PROBLEM - 1
Presently firms has debt - equity ratio of 2 and a & a  of 2.2. The firm now decides to
change the debt-equity ratio to a level of 1.2. What would be its new  use tax
rate = 30%.

Solution :

Step 1: Deleveraging

u
u 
D
1  1  t 
E
2.2

1  2  0.7 
2.2
U   U  0.92
2.4

Step 2 : Re leveragary

 D 
B L  B u  1  1  t  
 E 
 0.92 1  1.2  0.7  
βL  0.92  1  0.84 
 βL  1.69

PROBLEM - 2
RFreal  3%
Inflation premium = 6.5%
R m  15%
i. What is the equation of the SML.
ii. What is the new equation of the SML if inflation goes up to 7.5%
iii. What is the equation of the SML if market risk premium goes up by 20% of its
current level.
iv. What if there is a combination of ii & iii

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 Portfolio Management - Additional Practice Questions

Solution :

i. We have R f nominal = R real  inf lation

= 3 + 6.5
= 9.5%
R m = 15% (it is important to know that this is also nominal i.e it includes 6.5%)
 Market Risk Premium R m  R f
= 15 - 9.5 = 5.5%
 SML R e  R f   R m  R f  β
R e  9.5  5.5β

ii. Now, inflation premium = 7.5%

 R f no min al  3  7.5%
= 10.5%
Rm = 15 + 1 = 16%
 R m  R f = 16 - 10.5
= 5.5% (Same as earlier)
New SML= R e = 10.5 + 5.5 

iii. New R m  R f = 5.5 + 20% of 5.5

= 6.6%
 SML = R e  9.5  5.5β

iv. R e  10.5  6.6β

Note : The whole purpose of the above e.g. was to tell you that when inflation
changes, R m  R f will not change.

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 Strategic Financial Management

PROBLEM - 3

Investible fund = 5,00,000 on 1st Jan, 2017.

Client has mentioned that portfolio should not fall by more than 20%. Client has
agreed to a multiplier of 1.5. Rebalancing is to be done every quarter. R f  8% per
annum compound quarterly.
Current share price = 300.
Share price on 1st April = 330.
Share price on 1st July = 360.
Calculate the allocation of the portfolio into equity & bond initially & on each
rebalancing date.

Solution :

I. 1st Jan

A = 500000
F = 80%  5,00,000
= 4,00,000
M = 1.5
E = m(A - F)
= 1.5(5,00,000 - 4,00,000)  1,50,000}
Bond = 350,000

II. 1st April = New Price, 330.

330
Equity = 150000   165000
300
Bond = 3,50,000  1.02 = 357000
A=E+B 5,22,000
Floor  4,00,000  1.02
 408000
A - F = 114000
 Equity = 1.5  114000
= 1,71,000

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 Portfolio Management - Additional Practice Questions

Bond = 522000 - 1710000 = 351000

 Action Transfer `6000 from Bond to Equity

III. 1st July = New Price = 360

360
Equity = 171000   186545
330
Bond = 351000  1.02 = 358020
A = E + B  544565
Floor = 408000  1.02 = 416160
A - F  128405
Equity = 1.5  128405
= 192608
Bond = 544565 - 192608
= 351957
Action :- Transfer ` 6063 from Bond to Equity.

PROBLEM - 4

A conservative investor is analyzing the shares of PSEL which is currently trading at

Rs. 1,180. For the year 1999 - 2000, the earnings per share (EPS) was Rs. 40. The
investor has generated the following scenarios for the next year with the
corresponding probabilities:
P/E ratio EPS 20 30
50 0.20 0.35
60 0.30 0.15

You are required to calculate the expected risk and return for the share of PSPEL

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 Strategic Financial Management

Solution :

The current price of PSEL is Rs. 1180. The EPS is Rs. 40. Hence, the P/E ratio is
1180
 29.5
40
The various EPS and P/E ratios are given below.
(1) (2) (3) (4) (5) (6)
EPS P/E Ratio Probability Expected Expected Expected
Price (1 × 2) Return (Rs) Return (%)
50 20 0.20 1000 -180 (15.25)
50 30 0.35 1500 320 27.12
60 20 0.30 1200 20 1.69
60 30 0.15 1800 620 52.24

The expected return will be

E (P) = (-15.25 × 0.2) + (27.12 × 0.35) + (1.69 × 0.30) + (52.54 × 0.15)
= -3.05 + 9.49 + 0.507 + 7.88
= 14.827 or 14.83%
The risk of the stock is found below.
X X - X Prob X - X
2 2
X-X ×Prob
(15.25) (30.08) 904.81 0.20 180.96
27.12 12.29 151.04 0.35 52.86
1.69 (13.14) 172.66 0.30 51.80
52.54 37.71 1422.04 0.15 213.31
498.93

σ 2  p   498.93 %
2

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 Portfolio Management - Additional Practice Questions

PROBLEM - 5

Consider the following information relating to the returns from two stocks and the
market index in different economic scenarios:

Scenario Probability Stock A (%) Stock B (%) Return from

of scenario market index (%)
Boom 0.25 -15 -8 -7
Slow 0.10 19 -5 12
growth 0.45 35 25 20
Stagnation 0.20 15 18 25

From the above information, you are required to :

a. Calculate the ex-ante beta for the two stocks
b. Assuming that SML holds good, determine the Alpha of the two stocks and
comment on the same.
Also assume a risk free rate of interest of 7%.

Solution :

a. Market

RM Pi RMPi RM-E(RM) [RM- Square of deviations

E(RM)]2 ×Pi
-0.07 0.25 –0.0175 –0.2045 0.0418 0.01050
0.12 0.10 0.0120 –0.0145 0.0002 0.00002
0.20 0.45 0.0900 0.0655 0.0043 0.00190
0.25 0.20 0.0500 0.1155 0.0133 0.00270
0.1345 0.01512

Expected Return on market = 13.45

VarM = 0.01512
OM = 12.30%

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 Strategic Financial Management

Stock A

RA Pi RAPi RA-E(RA) RM-E(RM) Product Product × Pi

(1) (2) (3) (4) (5) (6) = (4) × (5) (7) = (6)× (2)
-0.15 0.25 –0.0375 –0.319 –0.2045 0.0652 0.0163
0.19 0.10 0.0190 0.021 –0.0145 –0.0003 –0.00003
0.35 0.45 0.1575 0.181 – 0.0655 0.0119 0.0054
0.15 0.20 0.0300 0.019 0.1155 –0.0022 –0.00043
0.1690 0.02124

Expected return on stock A = R A Pi  16.9%

Stock B

RB Pi R B Pi RB  E RB  RM  E RM  Product Product x Pi

(1) (2) (3) (4) (5) (6) = (4) × (5) (7) = (6) × (2)
–0.08 0.25 –0.0200 –0.2035 –0.2045 0.0416 0.01040
–0.05 0.10 –0.0050 –0.1735 –0.0145 0.0025 0.00025
0.25 0.45 0.1125 0.1265 +0.0655 0.0083 0.00370
0.18 0.20 0.0360 0.0565 0.1155 0.0065 0.00130
0.1235 0.01565

Expected Return on Stock B =  R B Pi = 12.35%

CovAM  R A - E  R A    R M - E  R M   Pi 0.02124

BetaA = = = =1.40
VarM VarM 0.01512
Cov BM 0.01565
Beta B = = = 1.04
VarM 0.01512

b. RA = R f +βA  R M - R f 
= 7 + 1.4 (13.45 – 7) = 16.03

A =E  RA  - Required return
= 16.9 – 16.03 = 0.87

As alpha is positive, Stock A is under valued

R B =7 + 1.04 (13.45 - 7) = 13.71

 B =12.35 - 13.71 = - 1.36
As alpha is negative, Stock B is overvalued.

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 Portfolio Management - Additional Practice Questions

PROBLEM - 6
Suppose the assumptions of CAPM are valid and unlimited borrowing and lending at
risk-less rate of interest is possible. You are required to determine the unknown
quantities in the following table.

Stock Expected Standard Beta Unsystematic Risk

Return (%) Deviation (%) (%)2
Super Cements 12 ? 1.52 15
Cresent Pharma ? 8 0.96 9
DFL Plastics 9 ? 0.80 25

Solution :

According to CAPM

Ri = Rf  β Rm  Rf 
RA = R f  βA  R m  R f  ..............................(I)
Rc = R f  β c  R m  R f  ...............................(II)
(I) - (II)

RA  RC =  βA  β C   R m  R f 
4 =  1.75  0.60  R m  R f 
4 = 1.15  R m  R f 
4
= 3.478   R m  R f 
1.15

Now putting the value of  R m  R f  in equation (I)

14 = R f  1.75  3.478
Rf = 14  6.087  7.913%
RB = 7.913  0.82  3.478 = 10.76%

Total risk = Systematic risk + Unsystematic risk

σ β2 = β B2 σ m2 +σ cB
2

6
2
= βB2 σ m2 +5

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 Strategic Financial Management

=  0.82  σ m2 +5
2
36
 36 - 5  = 0.6724 σ m2
31
= σ m2
0.6724
46.10 = σ m2
= 46.10   1.75   12  153.18
2
 A2
= 46.10   0.60   18  34.6
2
 C2
A = 12.38%
C = 5.88%

PROBLEM - 7

Given below are the risk estimates for two stocks X and Y:
Stock Covariance with Expected Firm Specific
the market Return Variance
X 435.6(%)2 14% 625(%)2
Y 580.8(%)2 18% 1,225(%)2

The risk-free rate of return is 6%, and the standard deviation of the returns on the
market index is 22%.
An investor is considering the following two alternatives for investing in the above
stocks:
i. Place equal proportion of his money in both the stocks.
ii. Place 25% of his money in Stock X, 40% of his money in stock Y and place his
remaining money in the risk-free T-Bills.
You are required to
a. Compute the total risk associated with stocks X and Y.
b. Calculate the expected return and the total risk associated with both the
alternatives. Which alternative should the investor prefer if he is considering
coefficient of variation as the benchmark?

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 Portfolio Management - Additional Practice Questions

Solution :
a.
Stocks Cov  Stock Mkt  SR =  2 2 m UR TR
β
σ2m
X 0.9 392.04 625 1017.04
Y 1.2 696.96 1225 1921.95

b. Alternative 1 : Place equal proportion of his money in both the stocks.

 2 P  x2 x2   2 y2  2xy  X Y   2 m
= 254.26 +480.49 +261.36
 2 P  996.11%2
14  18 
 P  31.56% E  RP   16% 
,  2 
SD 31.56
CV    100  197.25%
mean 16

Alternative 2 : Place 25% of his money in Stock X, 40% of his money in stock Y
and place his remaining money in the risk-free T-Bills.
 2 P   0.25 1017.04   0.4 192116
2 2
.  2  0.25  0.4  0.9 1.2  222
 63.565  307.51  104.54
= 475.615
 P  21.81%
E  RP   0.25  14  0.4  18  0.35  6
= 12.8%
SD 21.81
CV    170.39%
mean 12.8

 Alternative 2 should be choosen.

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 Strategic Financial Management

PROBLEM - 8

Consider the following data for two companies and the market:

Company/Market Beta Standard Covariance with

Deviation (%) Sensex (%)2
Zee Teleflims N.A. 45 205
Padmalay Teleflims 1.2 40 N.A
Teleflims Sensex 1.0 15 225

Further it is gathered that risk - free interest is 7%. Considering the assumptions of
regression (Characteristic) line hold good you are required to find.

a.
i. Beta of Zee Teleflims.
ii. Covariance of return on Padmalay Teleflims with that of return on sensex.

b. The coefficients of correlation between:

i. Return on Zee Teleflims and return on sensex.
ii. Return on Padmalaya Teleflims and return on Sensex.

c. The variance of the portfolio formed using Zee Telefilms and Padmalya Teleflims
in the proportion of 2/3 and 1/3 respectively.

d. Whether the unsystematic risk of the portfolio is less than individual companies?
(β of portfolio is weighted average betas of underlying stocks).

Solution :

a.
Cov  Zee,M 
i. βzzz 
Var  M 
0.0205
  0.91
 0.0225 

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 Portfolio Management - Additional Practice Questions

ii. Cov  Pad, M   βPad  Var  M 

= 1.2 × 0.0225
= 0.027 i.e. 270 (%2)

b.
Cov  zee, M 
i. ρzzz M 
σ zee  σ M
0.0205

0.45  0.0225
= 0.304

Cov  Pad.M 
ii. ρpad. M 
σ Pad  σ M
0.027

0.40  0.0225
= 0.45

c. Var (Portfolio)  W 2 zee σ 2 zee  W 2 Pad  2Wzee , Wpad Cov  Zee, Pad 

2
Wsee  ; σ zee  0.45
3
1
Wsee  ; σ pad  0.40
3

From the assumption of characteristic (Regression) line we get

Cov  zee, pad   βzee  βpad  Var  M 
= 0.91 × 1.2 × 0.0225
= 0.025 i.e, 250 (%2)

Variance (Portfolio)
2 2
2 1 2 1
     0.45       0.40   2    0.025
2 2

3 3 3 3
= 0.119 i.e, 1190 (%2)

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 Strategic Financial Management

d. Unsystematic Risk of Zee Telefilms

  1  ρ2 zee M  σ 2

  1   0.304     0.45 
2 2
 
= 0.184 i.e 1840 (%2)

Unsystematic Risk of Padmalay Telefilms

 
 1  ρ2 pad.M σ 2 Pad

  1   0.45     0.40 
2 2
 
= 0.128 i.e, 1280 (%2)
2 1
βportfolio  βzee  βpad
3 3
2 1
  0.91   1.2  1.007
3 3
Cov  Port.M 
ρ.Port.M 
σ port  σ M
σM
βport 
σPort
0.0225
 1.007   0.438
0.119

Unsystematic risk of portfolio

 
 1  ρ2 port .M σ 2 port

 1   0.438    0.119
2
 
= 0.096 i.e 960 (%2)

Therefore, we find that the unsystematic Risk of the portfolio is less than that of
individual stocks. From the result it can be implied that because of constitution of
portfolio unsystematic return reduces.

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 Portfolio Management - Additional Practice Questions

PROBLEM - 9

Mr. A. Rathi is testing the weak form efficient market hypothesis on the Indian stock
market. For this he has collected the data on a leading market index for the last 15
trading days. This is given below:

Trading day Market Index

1 4500
2 4550
3 4400
4 4350
5 4300
6 4330
7 4400
8 4445
9 4440
10 4370
11 4380
12 4365
13 4500
14 4560
15 4600

You are required to perform a runs test and determine the independence of data at
10% level of significance.

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Solution :
Trading day Market Index
1 4500
2 4550 + n1  8
3 4400 - n2  6
4 4350 -
5 4300 - r7
6 4330 +
7 4400 +
8 4445 +
9 4440 -
10 4370 -
11 4380 +
12 4365 -
13 4500 +
14 4560 +
15 4600 +

2n1n2
  1  7.86
n1  n2
   1   2 
  1.76
n1  n2  1
Case 1    10% significance (t = 1.771)
C    t  4.74
U    t  10.98
r i.e 7 lies between 4.74 & 10.98
Market is efficient in the weak form.

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