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200488 Corporate Financial Management

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200488 Corporate Financial Management

0 Download4 Pages / 768 Words

Course Code: 200488
University: Western Sydney University

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Country: Australia

Question:

What return is required to compensate for a given amount of risk?
The expected return of a security or a portfolio is equal to the risk free security and the risk premium. If the expected return is not more than (at least equal) the required return, then that investment should not be considered.
The systematic risk is measured by the security’s beta () coefficient, which is estimated as the slope coefficient of a regression of the security’s returns on the market portfolio returns (called the market model) (proxies, for example, by returns to the all ordinaries index for Australia).  
Some of the assumptions of the CAPM include:

the existence of a perfectly competitive capital market, in that the decision to buy/sell of any asset by any individual will not affect prices (all participants are price takers)
no impediments to transactions, no transaction costs, no taxes
all investors have the same information, and hold the same expectations about the probability distributions of returns of all assets
all investors are rational and risk averse

Difficulties with the CAPM:

In theory the inputs used in the SML equation should be known ex ante (i.e. what will be the rate of return on the market, or the asset’s beta), but our estimates of these inputs are based on historical (ex post) data.  This clearly leads to imprecision.
It is not particularly applicable to real assets that are not actively traded.

It is expected that students will try the problems below at home before attending the workshop. The lecturer will help to solve these problems during the workshop.
1.Under what condition will the population standard deviation of the return to a 2-asset portfolio be the weighted average of the two assets’ standard deviations of returns?  (Hint: Consider the formula for the standard deviation of the return to a 2-asset portfolio given in lectures, and recall from high school that
The possible rates of return you might expect by investing in shares C and D are as follows (assuming there are only three types of economic conditions):
(a) Calculate the expected returns and standard deviations for both shares C and D.  Express your answers as percentages rounded to 2 decimal places if required.
(b) Calculate the standard deviation of returns on a portfolio with asset weights of 70% and 30% for assets C and D, respectively.  Again express your answer as a percentage rounded to 2 decimal places if required.  (Hint: Start by working out the return on the portfolio in each type of economic conditions)
The following table shows the returns (in percent) on ordinary shares A and B in three possible states of nature, together with the probabilities of these states of nature occurring.
With reference to the above table:
(a) Calculate the expected return and standard deviation of returns for A shares and for B shares (separately).
(b) If a risk averse investor had to choose between holding A shares and holding B shares, which would he/she choose.  Give a reason for your answer.
(c) If an investor were to form a portfolio consisting of A and B shares, would it be possible for the portfolio to offer a lower standard deviation of returns than both A and B shares, and an expected return that is not lower than the expected returns of both shares?  Give a reason for your answer (Hint: you should be able to give a reason for your answer without having to perform any further calculations)

Answer:

Question 1 (a)
Refer excel, data has been downloaded and segregated for two periods as stated in the question.
Question 1(b)
Refer excel, return has been calculated by dividing July price by June price -1. Further, the risk free rate of return has been taken as it is provided in the question.
Accordingly, the return as required under the question has been calculated and tabulated.
Question 1(c)
Refer excel, the mean, standard deviation, variance and correlation coefficient has been computed by applying formulas in excel.
Further, on deriving the values the following understanding has been arrived:

For stock and Risk free rate of return (30-06-2015 to 29-02-2016), there exists a negative correlation of -0.403. Thus, the same can be used as a perfect hedging tool as the increase in return of one leads to decrease in other. Further, the risk profile is 3.98% as represented by standard deviation;
For stock and Risk free rate of return (29-02-2016 to 31-10-2017), there exists a negative correlation of -0.06. Thus, the same can be used as a hedging tool as the increase in return of one leads to decrease in other. Further, the risk profile is 15.97% which is represented by standard deviation and is high;
For market and Risk free rate of return (30-06-2014 to 29-02-2016), there exists a positive correlation of -0.0018. Thus, the same have a positive relationship i.e both return in same direction. However, the bonding of such movement is not so strong and is weak in nature. Further, the risk profile is 4.21% which is represented by standard deviation and is low;
For market and Risk free rate of return (29-02-2016 to 31-10-2017), there exists a negative correlation of -0.1538. Thus, the same can be used as a hedging tool as the increase in return of one leads to decrease in other. Further, the risk profile is 3.99% which is represented by standard deviation and is high;(Yahoo Finance, n.d.)

Question 1(d)
Refer Excel, for the computation of beta. The same has been computed by using the formula Covariance of stock and market / standard deviation of market.
Question 1(e)
The beta is a measure of systematic risk of the company. The beta of the two periods have been detailed here-in-below:

For 1stsub-period Beta is .00047 which is very low while the beta for the market stands at 1 representing a 1 AUD change in the market changes the price of share by .00047 AUD only. Thus, the share has a very less relation to the market;
For 2ndSub-period Beta is -0.0107 which is again very low while the beta for the market stands at 1 representing a 1 AUD  positive change in the market changes (decrease) the price of share by .0107 AUD. Thus, the share has a very less relation to the market. (Yahoo Finance, n.d.)

Question 1(f)
Adairs Limited is a public company listed on Australian Stock Exchange. The company has its headquarter in Melbourne, Australia. Adiars is engaged in the business of retailing of homewares and home furnishing. The services offered by the company ranges from product designing, development, sourcing, distribution and retail operations. There are two segments of business core and staple category and fashion and decorator product categories.
Adairs staple category of business comprise plain bed linen, bedding and towelling products. Further, the fashion and decorator category products encompasses fashion bed linens, soft furnishings, bedroom furniture and occasional furniture. The company market its product under its own brand. The company is running approximately 130 stores in Australia under five different physical formats. (Reuters, 2018)The name of those outlets are detailed here-in-below:

Adairs;
Adairs kids;
Adairs Homemakers;
Urban Home Republic (UHR);p
Adiars Outlets.

Question 1(g)
The beta for two period shall be different on the basis of various factors and one cannot actually ascertain the reason for such change. The following are some of the factors whioch are responsible for change in beta:

Market is dynamic;
Change in variables related to business cycle of the company;
Time varying market conditions;
Firm specific conditions like debt, production etc;
Change in risk profile of the company;
Investor expectation about the future prospect of the company;
Resignation of Key Managerial Personnel;
Market Volatility;
Global economic conditions etc

References:
Reuters, 2018, Adairs Ltd (ADH.AX,. [Online] Available at: https://www.reuters.com/finance/stocks/companyProfile/ADH.AX[Accessed 17 September 2018].
Yahoo Finance, n.d, Adairs Limited, [Online] Available at: https://au.finance.yahoo.com/quote/ADH.AX/profile?p=ADH.AX[Accessed 17 September 2018].
Yahoo Finance, n.d. Adairs Limited, [Online] Available at: https://au.finance.yahoo.com/quote/ADH.AX/profile?p=ADH.AX[Accessed 17 September 2018].

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