SIMAD UNIVERSITY

LEARNING OBJECTIVES

portfolio theory , how to calculate

CAPM, how to calculate

.

Portfolios theory

Lecturer: Yusuf H. Mohamed

Corporate finance

hand out CH8 and Ch09

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SIMAD UNIVERSITY
Portfolios A portfolio is a group of assets held by an investor.

Portfolio Weights The respective percentages of a portfolios total value invested in

each of the assets in the portfolio. Portfolio weights must sum to 1.0.

Portfolio Expected Returns The expected return for a portfolio is the weighted average
of the expected returns of the assets which are included in the portfolio:
An efficient portfolio is one that offers:
A. the most return for a given amount of risk, or
B. the least risk for a given amount of return.
The collection of efficient portfolios is called the efficient set or efficient frontier.

The characteristics of individual securities that are of interest are the:

Expected Return

Variance and Standard Deviation

Example

Consider the following two risky asset world. There is a 1/3 chance of each state of the economy and the
only assets are a stock fund and a bond fund.

Lecturer: Yusuf H. Mohamed

Corporate finance

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SIMAD UNIVERSITY

E (rp ) W1 E (r1 ) W2 E (r2 )

Variance

Rate of return
Expected Return) 2

(11% 7%) 3.24%

2

portfolio | W1 1 W2 2 |

The volatility (StD) of portfolio return is:

Note that stocks have a higher expected return than bonds and higher risk. Let us turn now to the
risk-return tradeoff of a portfolio that is 50% invested in bonds and 50% invested in stocks

Lecturer: Yusuf H. Mohamed

Corporate finance

hand out CH8 and Ch09

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SIMAD UNIVERSITY

The rate of return on the portfolio is a weighted average of the returns on the stocks and bonds in
the portfolio:

r
P

r
B

r
S

The expected rate of return on the portfolio is a weighted average of the expected returns
on the securities in the portfolio.

E (r ) w E (r ) w E (r )
P

Lecturer: Yusuf H. Mohamed

Corporate finance

hand out CH8 and Ch09

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SIMAD UNIVERSITY
Capital Asset pricing model

The Capital Asset Pricing Model (CAPM) uses a mathematical model to create a
percentage representation of the risk for an investment (Byrd, Hickman, & McPherson,
2013).

The Capital Asset Pricing Model, or CAPM, is a theory of the relationship between risk and
return and explains how financial assets are priced under certain conditions.

CAPM important

First, it provides a theoretical justification for the widespread practice of passive

investing

Second, the CAPM provides a way of estimating expected rates of return for use in a
variety of financial applications known as indexing

The required return for all assets is composed of two parts: the risk-free rate and a risk
premium.
The risk premium is a function of both market conditions and the asset itself.

The risk premium for a stock is composed of two parts:

A. The Market Risk Premium which is the return required for investing in any risky
asset rather than the risk-free rate
B. Beta, a risk coefficient which measures the sensitivity of the particular stocks
return to changes in market condition
ki = RF + [bi x (km - RF], where
ki = an assets expected or required return,
RF = the risk free rate of return,
bi = an asset or portfolios beta
km = the expected return on the market portfolio.

Example

Lecturer: Yusuf H. Mohamed

Corporate finance

hand out CH8 and Ch09

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SIMAD UNIVERSITY
Example
Calculate the required return for Federal Express assuming it has a beta of 1.25, the rate on US T-bills is
5. %, and the expected return for the S&P 500 is 15%.

Solution
ki =.05 + 1.25 [.15 - 0.o5]
ki = 17.5%
Test

If the risk-free rate equals 4% and a stock with a beta of 0.75 has an expected return of 10%, what
is the expected return on the market portfolio? Answer KM=11.5

Lecturer: Yusuf H. Mohamed

Corporate finance

hand out CH8 and Ch09

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SIMAD UNIVERSITY
Problems
Problem one

Star portfolio holds security A, which returned 12.0%, security B, which returned 15.0% and
security C, which returned 5.0%. At the beginning of the year 45% was invested in security A,
25.0% in security B and the remaining 30% was invested in security C. The correlation between
AB is 0.75, between AC 0.35, and between BC 0.5. Securities As standard deviation is 12%,
security Bs standard deviations is 15% and security Cs is 10%.
Instruction
Calculate the expected return of Stars Portfolio, the portfolio variance and standard deviation.
Problem two

A sset
A
B
C
D

P o rtfo lio w e ig h t
.3 5
.1 5
.2 5
.2 5

R e tu rn
20%
35%
6%
12%

Find the expected portfolio return

Problem three
A. The beta of hormuud , Inc., stock is 1.6, whereas the risk-free rate of return is 8 percent. If the
expected return on the market is 15 percent, then what is the expected return on hormuud?
B. The expected return on Discount Computers stock is 16.6 percent. If the risk-free rate is 4 percent
and the expected return on the market is 10 percent, then what is Discount computer 's beta?
C. The expected return on Kaah Co. stock is 16.5 percent. If the risk-free rate is 5 percent and the ta
of Kaah Co is 2.3, then what is the risk premium on the market
Problem four
Suppose an investor has an investment portfolio comprised of 1,000 shares of LEH (Beta = 2.04) at 31.40,
100 FSLR (Beta = 0.03) at 288.50, and 5,000 of EFTC (Beta = 1.09) at 3.95. Calculate the beta of this
three-stock portfolio.

Problem five

Lecturer: Yusuf H. Mohamed

Corporate finance

hand out CH8 and Ch09

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SIMAD UNIVERSITY
Suppose you invest $600 in IBM and $400 in Oracle for a month. If the realized return is 2.5% on IBM
and 1.5% on oracle over the month, what is the return on your total portfolio?
Problem six
You are thinking about investing your money in the stock market. You have the following two stocks in
mind: stock A and stock B. You know that the economy can either go in recession or it will boom. Being
an optimistic investor, you believe the likelihood of observing an economic boom is two times as high as
observing an economic depression. You also know the following about your two stocks:
State

of

the

Probability

RA

RB

Boom

10%

2%

Recession

6%

40%

Economy

a) Calculate the expected return for stock A and stock B

b) Calculate the total risk (variance and standard deviation) for stock A and for stock B
c) Calculate the expected return on a portfolio consisting of equal proportions in both stocks.
d) Calculate the expected return on a portfolio consisting of 10% invested in stock A and the remainder
in stock B.
Problem seven
If the risk free rate is 12 percent and the market risk premium is 6 percent, what is the required rate of
return on the Apple Fund?
Problem eight

Stock A has a beta of 1.2, Stock B has a beta of 0.6, the expected rate of return on an average
stock is 12 percent, and the risk-free rate of return is 7 percent. By how much does the
required return on the riskier stock exceed the required return on the less risky stock?

Problem nine
You are managing a portfolio of 10 stocks which are held in equal dollar amounts. The current
beta of the portfolio is 1.8, and the beta of Stock A is 2.0. If Stock A is sold and the proceeds are

Lecturer: Yusuf H. Mohamed

Corporate finance

hand out CH8 and Ch09

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SIMAD UNIVERSITY
used to purchase a replacement stock, what does the beta of the replacement stock have to be to
lower the portfolio beta to 1.7?
Problem ten
If the risk-free rate is 8 percent, the expected return on the market is 13 percent, and the expected
return on Security J is 15 percent, then what is the beta of Security J?
Problem eleven
Consider the following information for the Alachua Retirement Fund, with a total investment of
$4 million.
Stock

Investment

Beta

$ 400,000

1.2

600,000

-0.4

1,000,000

1.5

2,000,000

0.8

Total

$4,000,000

The market required rate of return is 12 percent, and the risk-free rate is 6 percent. What
is its required rate of return?

To enable the student to estimate company, divisional,

and project cost of capital
To understand and analyze complex projects where the
Lecturer:
H. Mohamed
handthe
outlife
CH8
Ch09
risk ofYusuf
the project
changes over
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the project
Corporate finance

Learning objective

SIMAD UNIVERSITY

What is cost of capital?

Cost of capital is the weighted average of the required returns of the securities that are used to
finance the firm. We refer to this as the firms Weighted Average Cost of Capital, or WACC.

Most firms raise capital with a combination of debt, equity, and hybrid securities.

WACC incorporates the required rates of return of the firms lenders and investors and the
particular mix of financing sources that the firm uses.
Why Cost of Capital Is Important

We know that the return earned on assets depends on the risk of those assets

The return to an investor is the same as the cost to the company

Our cost of capital provides us with an indication of how the market views the risk of our assets

Knowing our cost of capital can also help us determine our required return for capital budgeting
projects

Three Steps to Calculating Cost of Capital

1. Calculate the value of each security as a proportion of the firms market value.
2. Determine the required rate of return on each security.
3. Calculate a weighted average after tax return on the debt and the return on the equity.

If a firm uses both debt and equity to finance its investments, we need to use overall cost of
capital as the discount rate

rwacc = (S/V rs) + (D/V rD (1-Tc)) or

Where

rwacc = the weighted average cost of capital

S = market value of equity D = market value of debt

V = total market value of the firm (D+S) , rs = cost of equity

rD = cost of debt, Tc = corporate tax rate

Lecturer: Yusuf H. Mohamed

Corporate finance

hand out CH8 and Ch09

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SIMAD UNIVERSITY

Example - Executive Fruit has issued debt, preferred stock and common stock. The market value of
these securities are $4mil, $2mil, and $6mil, respectively. The required returns are 6%, 12%, and 18%,
respectively.

Determine the WACC for Executive Fruit, Inc.

Example - continued

Step 1
Firm Value = 4 + 2 + 6 = $12 mil

Step 2
Required returns are given

Step 3

WACC = 124 x(1 - .35).06 + 122 x.12 + 126 x.18

= .123 or 12.3%

Lecturer: Yusuf H. Mohamed

Corporate finance

hand out CH8 and Ch09

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SIMAD UNIVERSITY

Example two

Best Quality building material company has issued debt 0.3, preferred stock 0.1 and common stock 0.6
respectively. The required returns are 11%, 10.3%, and 14.6%, respectively. Corporate tax 40%
Answer
WACC =0.3(11%)(1-.40)+0.1(10.3%)+0.6(14.6%)
WACC = 11.77%
Find Cost Required of P E And D

Cost of Preferred Stock

Cost of Preferred Stock is the required rate of return on investment of the preferred shareholders of the
company.
kP = DP / P0

Determination of the Cost of Preferred Stock

Assume that Basket Wonders (BW) has preferred stock outstanding with par value of $100, dividend per
share of $6.30, and a current market value of $70 per share.
kP = $6.30 / $70
kP = 9%

Constant Growth Model

The constant dividend growth assumption reduces the model to:

ke = ( D1 / P0 ) + g
Assumes that dividends will grow at the constant rate g forever.

Determination of the Cost of Equity Capital

Assume that Basket Wonders (BW) has common stock outstanding with a current market value of $64.80
per share, current dividend of $3 per share, and a dividend growth rate of 8% forever.
ke

= ( D1 / P0 ) + g

ke

= ($3(1.08) / $64.80) + .08

Lecturer: Yusuf H. Mohamed

Corporate finance

hand out CH8 and Ch09

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SIMAD UNIVERSITY
ke

= .05 + .08 = .13 or 13%

Capital Asset Pricing Model

The cost of equity capital, k e, is equated to the required rate of return in market equilibrium. The riskreturn relationship is described by the Security Market Line (SML).
ke = Rj = Rf + (Rm - Rf)bj
Determination of the Cost of Equity (CAPM)
Assume that Basket Wonders (BW) has a company beta of 1.25. Research by Julie Miller suggests that
the risk-free rate is 4% and the expected return on the market is 11.2%
ke

= Rf + (Rm - Rf)bj
= 4% + (11.2% - 4%)1.25

ke

= 4% + 9% = 13%

Before-Tax Cost of Debt Plus Risk Premium

The cost of equity capital, ke, is the sum of the before-tax cost of debt and a risk premium in expected
return for common stock over debt.
ke = kd + Risk Premium*
* Risk premium is not the same as CAPM risk premium

Determination of the Cost of Equity (kd + R.P.)

Assume that Basket Wonders (BW) typically adds a 3% premium to the before-tax cost of debt.
ke

= kd + Risk Premium
= 10% + 3%

ke

= 13%

Lecturer: Yusuf H. Mohamed

Corporate finance

hand out CH8 and Ch09

13

SIMAD UNIVERSITY

Problem
Problem one
Suppose that Star, Inc.s capital structure features 65 percent equity, 35 percent debt, and that its beforetax cost of debt is 8 percent, while its cost of equity is 13 percent. If the appropriate weighted average tax
rate is 34 percent, what will be Stars WACC? Ans WACC 10.298%
Problem two
Hormuud has 6.5 million shares of common stock outstanding with a market price of $14.00 per share.
The company also has outstanding preferred stock with a market value of $10 million, and 25,000 bonds
outstanding, each with face value $1,000 and selling at 90% of par value. The cost of equity is 14%, the
cost of preferred is 10%, and the cost of debt is 7.25%. If hormuud tax rate is 34%, what is the WACC?
Ans WACC 11.993%
Problem three
Suppose that BEST Quality building material . has a capital structure of 78 percent equity, 22 percent
debt, and that its before-tax cost of debt is 11 percent while its cost of equity is 17 percent. If the
appropriate weighted average tax rate is 25 percent, what will be BQBMs WACC? Ans =15.075%
Problem four
Suppose that Dulqaad capital structure features 63 percent equity, 7 percent preferred stock, and 30
percent debt. If the before-tax component costs of equity, preferred stock and debt are 11.60 percent, 9.5
percent and 7 percent, respectively, what is Dulqaad s WACC if the firm faces an average tax rate of
34%? Ans 9.359%
Problem Five
Suppose that Brown-Murphies common shares sell for $19.50 per share, are expected to set their next
annual dividend at $.57 per share, and that all future dividends are expected to grow by 4 percent per year,
indefinitely. If Brown-Murphies faces a flotation cost of 13% on new equity issues, what will be the
flotation-adjusted cost of equity?

Lecturer: Yusuf H. Mohamed

Corporate finance

hand out CH8 and Ch09

14