FIN3080 Investment Analysis and Portfolio Management

Assignment 2 (Due date: April 16, 2011)

Question 1

A. As the manager of a large, broadly diversified portfolio of stocks and bonds,

you realize that changes in certain macroeconomic variables may directly
affect the performance of your portfolio. You are considering using an
arbitrage pricing model (APT) approach to strategic portfolio planning and
want to analyze the possible impacts of the following four factors:
• Industrial production
• Inflation
• Risk premium or quality spreads
• Yield curve shifts
Indicate how each of these four factors influences the cash flows and/or the
discount rates in the traditional discounted cash flow model. Explain how
unanticipated changes in each of these four factors could affect portfolio
returns.

B. Jeffrey Bruner uses the capital asset pricing model (CAPM) to help identify
mispriced securities. A consultant suggests Brunner use the arbitrage pricing
theory (APT) instead. In comparing the CAPM and the APT, the consultant
made the following arguments:
a. Both the CAPM and APT require a mean-variance efficient market
portfolio.
b. Neither the CAPM nor APT assumes normally distributed security
returns.
c. The CAPM assumes that one specific factor explains security
returns, but the APT does not. State whether each of the consultant’s
argument is correct or incorrect. Indicate, for each incorrect
argument, why the argument is incorrect.

Question 2

Portfolio A has an expected return of 10.25 percent and a factor sensitivity of 0.5.
Portfolio B has an expected return of 16.2 percent and a factor sensitivity of 1.2. The
risk-free rate is 6 percent, and there is one factor. Determine the factor’s price of risk.

Question 3

A wealthy investor has no other source of income beyond her investments. Her
investment advisor recommends that she tilt her portfolio to cyclical stocks and high-
yield bonds because the average investor holds a job and is recession sensitive.
Explain the advisor’s advice.
Quesstion 4

A porrtfolio manaager uses thee multifactor model show

wn in the folllowing tablee:

The S&P
S 500 is the
t benchmaark portfolio for Portfolioos A and B. Calculate thhe weights
the manager
m wouuld put on Po ortfolios A annd B to havee zero excess business cyycle
factorr sensitivity (relative to the
t businesss cycle sensittivity of the S&P 500). Then
T
calcuulate the inflaation factor sensitivity
s o the resultinng portfolio.
of

Quesstion 5

Suppose that an institution

i hoolds Portfoliio K. The insstitution wannts to use Poortfolio L
to heddge its exposure to inflaation. Specifiically, it wan
nts to combinne K and L to t reduce
its infflation exposure to 0. Poortfolios K aand L are well diversifiedd, so the mannager can
ignorre the risk off individual assets
a and asssume that thhe only sourrce of uncertaainty in
the poortfolio is th
he surprises in
i the two faactors. The reeturns to thee two portfollios are
RK = 0.12 + 0.5FINFL + 1.0F FGDP
RL= 0.11
0 + 1.5FIINFL + 2.5FGDP
Calcuulate the weiights that a manager
m shoould have on K and L to achieve this goal.
Question 6

Firm A Firm B Firm C Firm D

Book Value of Equity $100 $100 $100 $100
Return on Equity (ROE) 12% 12% 15% 15%
Earnings per share $12 $12 $15 $15
Payout Ratio 33 % 100% 100% 33 %
Required Rate of Return on Equity 12% 12% 12% 12%

The above table shows the book value of equity, return on equity, earnings per share,
payout ratio and the required rate of return for Firm A, B, C and D. Firm A maintains
a constant dividend payout policy (i.e., the dividend payout is maintained at 33 % of
earnings) and expects to grow at a steady rate per year far into the future. Firm B is
similar to Firm A, but Firm B pays out all its earnings every year. Firm C and Firm D
have higher return on equity and have different dividend payout policies.

a. Estimate the fundamental growth rate of dividends using return on equity and
payout ratio for each firm.
b. Estimate the stock value for each firm using dividend discounted model.
c. Estimate the price earnings (P/E) ratio for each firm.
d. Which firm has the higher P/E ratio? Explain why.

Question 7

Sundanci actual 2007 and 2008 financial statements for fiscal years ending May 31
($ million, except per share data)

Income Statement 2007 2008

Revenue 474 598
Depreciation 20 23
Other operating costs 368 460
Income before taxes 86 115
Taxes 26 35
Net Income 60 80
Dividends 18 24
Earnings per share 0.714 0.952
Dividend per share 0.214 0.286
Common shares outstanding (millions) 84.0 84.0
Balance Sheet 2007 2008
Current assets 201 326
Net property, plant and equipment 474 489
Total assets 675 815
Current liabilities 57 141
Long term debt 0 0
Total liabilities 57 141
Shareholders’ equity 618 674
Total liabilities and equity 675 815
Capital expenditures 34 38
Required rate of return 14%
Growth rate of industry 13%
Industry P/E ratio 26

Abbey Naylor has been directed to determine the value of Sundanci’s stock using the
Free Cash Flow to Equity (FCFE) model. Naylor believes that Sundanci’s FCFE will
grow at 27% for 2 years and 13% thereafter. Capital expenditures, depreciation and
working capital are all expected to increase proportionally with FCFE.

a. Calculate the amount of FCFE for the year 2008, using the above data.

b. Calculate the current value of a share of Sundanci stock based on the two-
stage FCFE model.

c. i. Describe one limitation of the two-stage DDM model that is addressed by

using the two-stage FCFE model.
ii. Describe one limitation of the two-stage DDM model that is not addressed
by using the two-stage FCFE model 

d. Discuss how we can estimate the growth rates used in the DDM and the FCFE
model. Are they the same?