Question

12. Portfolio beta and weights Eric is an analyst at a wealth management firm. One of his clients holds a $7,500 portfolio that consists of four stocks. The investment allocation in the portfolio along with the contribution of risk from each stock is given in the following table: Investment Allocation Standard Deviation Stock Atteric Inc. (AI) Beta 0.750 35% 0.53% 20% 1.500 0.57% Arthur Trust Inc(AT) 0.60% Lobster Supply Corp. (LSC) Transfer Fuels Co. (TF) 15% 30% 1.100 0.500 0.64% Eric calculated the portfolio's beta as 0.878 and the portfolio's expected return as 10.71%. Eric thinks it will be a good idea to reallocate the funds in his client's portfolio. He recommends replacing Atteric Inc.'s shares with the same amount in additional shares of Transfer Fuels Co. The risk-free rate is 5.00%, and the market risk premium is 6.50%. According to Eric's recommendation, assuming that the market is in equilibrium, the portfolio's required return will change by jective and Analysts' estimates on expected returns from equity investments are based on several factors. These estimations also often in often ir 0.44% judgmental factors, because different analysts interpret data in different ways. 0.66% 0.71% Does he think Suppose, based on the earnings consensus of stock analysts, Eric expects a return of 10.13% from the portfolio with the new that the revised portfolio, based on the changes he recommended, is undervalued, overvalued, or fairly valued? 0.57% Overvalued Undervalued Fairly valued


increase/decrease

Answer 1

New Allocation on Transfer co = 30%+35% = 65%
Beta after new allocation =20%*1.50+15%*1.10+65%*0.5 = 0.79
New Required rate = Risk free rate + Beta* Market risk premium = 5%+ 0.79* 6.5% =10.135% or 10.14%

The change in required rate =10.71%- 10.14% =0.57%
The project is Overvalued if Eric expects 10.13% as it is less than 10.135%

If Higher beta is chosen the portfolio beta would increase.