FINANCIAL MANAGEMENT SOME OF EXERCISES DONE FOR : CHAPTER 2, CHAPTER 3 AND CHAPTER 4 RISK, RETURN, INVESTMENT DIVERSIFICATION 1.

Exercise 1
Table 1: Jenson & Nicholson's dividend and market per share, 2002-2007

Illustra tion: Jensen &Nic holson, apa com ny, ha the following int pa s dividend per sha (D and the m rket pric per sha (AMP) for the period re IV) a e re 2 0 -2 0 02 07 Ya er 20 02 20 03 20 04 20 05 20 06 20 07 D ($ IV ) 1 3 .5 1 3 .5 1 3 .5 2 0 .0 2 0 .0 3 0 .0 A P($ M ) 3 .2 1 5 2 .7 0 5 3 .8 0 8 6 .0 7 0 10 0 0 .0 14 0 5 .0

Calculate the annual rates of return of Jonsons shares for the last five years. How risky is the share? The annual rates of return can be calculated by using equation:

To determine the riskiness of Jensons share we can calculate the standard deviation of the rates of return as follows:

= 48.28 The standard deviation of Jensons share is quite high. The share is very risky.

2. Kigali Corporation Company LtD has an expected return of 22% and standard deviation of 40%. Kigali Import-Export Company has an expected return of 24% and standard deviation of 38%. KCC has a beta of 0.86 and KIEC 1.24. The correlation between the returns of KCC and KIEC is 0.72. The standard deviation of the market return is 20%. a) Is investing in KIEC better than investing in KCC? b) If you invest 30% in KIEC and 70% in KCC, what is your expected rate of return and the portfolio standard deviation? c) What is the market portfolios expected rate of return and how much is the risk-free rate? d) What is the beta of portfolio if KCCs weight is 70% and KIEC is 30%?

Solution: a) KCC has lower return and higher risk than KIE. However investing in both will yield diversification advantage
b) Rp = (22 x 0.7) + (24 x 0.3) = 22.6%

1) Var = (40 x 0.7) + (38 x 0.3) + (2 x 0.7 x 0.3 x 0.72 x 40 x 38) = 1374 2) Standard deviation = 37%

c) The risk-free rate will be the same for KCC and KIEC. Their rates of return are given as follows: Rkcc = 22 = rf + (rm rf)0.86 Rkiec = 24 = rf + (rm rf)1.24 Rkcc - Rkiec = -2 = (rm rf) (-0.38) rm rf = - 2/(-0.38) = 5.26% rkcc = 22 = rf + (5.26)0.86 rf = 17.5% rkiec = 24 = rf + (5.26)1.24 rf= 17.5% rm 17.5 = 5.26 rm = 22.76%
d) kcckiec = kcc x wkcc + kiec x wkiec = (0.86 x 0.7) + (1.24 x 0.3) = 0.974

2. An investor holds two equity shares x and y in equal proportion with the following risk and return characteristics: E(Rx) = 24% x = 28% E(Ry) = 19% y = 23%

The returns of these securities have a positive correlation of 0.6. You are required to calculate the portfolio return and risk. Further, suppose that the investor wants to reduce the portfolio risk (p) to 15%. How much should the correlation coefficient be to bring the portfolio risk to the desired level?

SOLUTION:

The portfolio return is: E(Rp) = 24(0.5) + (19(0.5) = 21.5% And the portfolio risk is : p = (28)(0.5) + (23)(0.5) + 2(0.5)(0.5)(28)(23)(0.6) = 196 + 132.25 + 193.2 = 521.45 p = 22.84% if the investor desires the portfolio standard deviation to be 15%, the correlation coefficient will be as computed below: (15) = (28)(0.5) + (23)(0.5) + 2(0.5)(0.5)(28)(23)xy 225 = 196 + 132.25 + 322 xy xy = (-103.25)/322 = -0.321

3. A portfolio consists of three securities P, Q and R with the following

parameters P Expected return (%) Standard 25 30 Q 22 26 R 20 24 Correlation Coefficient

deviation (%) Correlation Coefficient PQ -0.5 QR +0.4 PR +0.6

If the securities are equally weighted, how much is the risk and return of the portfolio of these three securities? SOLUTION The portfolio return is: E(Rp) = (25)(1/3) + 22(1/3) + 20(1/3) = 22.23% p = (30)(1/3) + (26)(1/3) + (24)(1/3) + 2(1/3)(1/3)(-0.5)(30)(26) + 2(1/3) (1/3)(0.4)(26)(24) + 2(1/3)(1/3)(0.6)(30)(24) = 100 + 75.11 + 64 86.67 + 55.47 + 96 = 303.91 p = 17.43%

4. Assume that we have the following data for the company X:

a. Risk-free rate: 3.3%

b. Expected return of the market portfolio: 10.2% c. Correlation coefficient between j and the market portfolio: 0.25 d. Standard deviation for j: 15% e. Market portfolio standard deviation: 25% Calculate the expected return on security j SOLUTION:

E(Rj) = rf + (Rm rf) = 3,3% + 0,15(10,2% -3,3%) = 0,04335 = 4,3%

CAPITAL STRUCTURE 1. You have the Statement of financial position for Company X RWF RWF million million Assets: Non-current assets (total) 23 Current assets (total) 15 Total assets 38 Equity and liabilities: Ordinary share capital 10 Ordinary share premium 3 Preference share capital 1.5 Reserves 2.5 17 Loan notes 10% 8 Current liabilities: Trade payables 8 Bank overdraft 5 13 Total equity and liabilities 38

Calculate the equity gearing and capital gearing of the business Solution: Debt million Equity RWF15.5 million Equity gearing : (RWF14.5/RWF15.5 million) x 100 = 93.5% : RWF10 million + RWF3 million + RWF2.5 million = : RWF5 million + RWF8 million + RWF1.5 million = RWF14.5

Capital gearing 43.3%

: RWF14.5 million/(RWF14.5 million + RWF15.5 million) =

2. A company is an all-equity company with a beta of 0.8. It is appraising a

one-year project which requires an outlay now of RWF600,000 and will generate cash in one year with an expected value of RWF750,000. The project has a beta of 1.3. rf = 10%, rm= 18%. a) What is the firms current cost of equity capital? b) What is the minimum required return of the project? c) Is the project worthwhile? Answer: a) Cost of capital = 10% + (8% x 0.8) = 16.4% b) Project required return = 10% + 1.3(18% - 10%) = 20.4% c) Expected project return:

Thus the project is worthwhile because its expected rate of return is higher than its minimum required return.

3. A company is about to embark upon a major diversification in the

consumer electronics industry. Its current equity beta is 1.2, whilst the average equity of electronics firms is 1.6. Gearing in the electronics industry averages 30% debt, 70% equity. Corporate debt is considered to be risk free. Rm = 25%, Rf = 10%, corporation tax rate = 30%

What would be a suitable discount rate for the new investment if the company were to be financed in each of the following ways? a) By 30% debt and 70% equity b) Entirely by equity c) By 20% debt and 80% equity d) By 40% debt and 60% equity Answer In all four situations the best approach is to treat the project as a mini-firm and tailor the discount rate to reflect its level of systematic business risk and financial risk. a) By 30% debt and 70% equity In this case the observed equity beta of the electronics industry would reflect the level of business risk and financial risk of the project. No adjustments are therefore required and the average equity of the electronics industry can be used. To obtain a suitable discount rate we must simply weight the cost of equity and the cost of debt, hence:

ke = Rf + (Rm Rf) = 10% + 1.6(25% - 10%) = 34% kd = Rf(1 t) = 10%(1 0.30) = 7% Suitable discount rate for project = (34% x 0.7) + (7% x 0.3) = 25.9% It is the WACC which is needed as the discount rate, not just the cost of equity, since the project is to be financed by a mix of debt and equity.

b) Project financed entirely by equity To reflect the business risk of the new venture we should start with the equity of the electronics industry, i.e. 1.6. As the project is to be ungeared we should then remove the financial risk element:

The pure cost of equity (and hence WACC in the all-equity case) would then be: ke = Rf + (Rm Rf)= 10% + 1.23(25% - 10%) = 28.45% The project should be evaluated at a rate of 28.45% c) Project financed by 20% debt and 80% equity In this case the equity beta of the electronics industry reflects a higher level of gearing than that for the proposed project. The simplest procedure is to take a two-step approach to the gearing adjustment. Step 1: calculate the asset beta for the electronics company (as in (b)). asset = 1.23 This is a measure of the pure systematic risk of electronics companies. We now adjust this pure beta in the light of the given financial gearing ratio. Step 2: Work out the equation backwards to calculate the cost of equity for an electronics company with 80% equity and 20% debt.

The cost of equity for such a firm would then be: ke = Rf + (Rm Rf) = 10% + 1.45(25% - 10%) = 31.75% the cost of debt would be as before: kd = Rf(1 t) = 10%(1 0.30) = 7% and a suitable discount rate for the project would be:

d) Project financed by 40% debt and 80% equity In this case the equity beta of the electronics industry reflects a lower level of gearing than that for the proposed project. The process is the same seen in part(c). Step 1: Calculate the asset beta for the electronics company (as in (b)). asset = 1.23 Step 2: Work out the equation backwards to calculate the cost of equity for an electronics company with 60% equity and 40% debt.

The cost of equity for such a firm would then be: ke = Rf + (Rm Rf) = 10% + 1.80(25% - 10%) = 37%

The cost of debt would be as before = 7% and a suitable discount rate for the project would be: