PAI Econ5027_Answer Guide for In-Course Exam

QUESTION 1

Suppose that investor A holds a portfolio (portfolio A) consisting of five shares. The portfolio return is equal to 10% while its risk (st.dev) equals 12%. The market portfolio (consisting of all n shares) at this point of reference rewards investors with 15% and its risk is equal to 10%.

1. a) Is this portfolio (portfolio A) an efficient one? Explain.
2. b) Suppose that the risk free interest rate is 2%. What is the diversification benefit of another investor (investor B) who holds a perfectly diversified portfolio (portfolio B) that embeds the same level of risk with that of portfolio A

(i.e. ==12%)? Explain. c) Howthisportfolio(portfolioB)canbeconstructed?Explain.

d) How does the existence of the risk free interest rate affect the optimum portfolio construction? Explain.

QUESTION 2

Suppose that you are investigating two mutual exclusive investments (investment A and B) which correspond to two listed firms A and B, respectively. The NCFs of these investments are the following:

t0 t1 t2 t3

1. A (10,000) 11,500 200 100
2. B (10,000) 0 0 14,000

The risk free interest rate is 2% and the market portfolio return is 7%.

1. a) If the beta coefficient (systematic risk) for firm A and B is equal to 0.5 (i.e. bA=bB=0.5) which investment would you proceed with according to the Net Present Value (NPV) and the Internal Rate of Return (IRR) investment appraisal techniques? Is there any difference in the decisions made, based on the NPV and the IRR criteria? Explain.
2. b) If the beta coefficient (systematic risk) for firm A and B is equal to 1.65 (i.e. bA=bB=0.5) which investment would you proceed with according to the Net Present Value (NPV) and the Internal Rate of Return (IRR) investment appraisal techniques? Is there any difference in the decisions made, based on

the NPV and the IRR criteria? Explain.