Question

Sally Tao graduated from the University of Adelaide in 2014, and after working for five years, has managed to save $300,000, assisted by a recent bequest of $200,000 from a deceased relative, that is currently earning 1.2% annual interest in a term deposit account with her bank. Sally is interested in investing her entire savings in shares, and recalls a University friend who was studying finance mentioning the advantages of investing in a portfolio and the concept of systematic risk. After discussions with a financial adviser Sally has decided that she would like to invest her money in two companies, namely Skenes Industries and Torrens Minerals. Through a search of various internet sites she has found that shares in Skenes have a beta of 1.40, and shares in Torrens 0.8. In addition, her financial advisor has noted that the general consensus amongst financial analysts is that the current expected return on the stock market index is 5.2% and the risk-free rate is 1.8%. A) What is the expected return on each of these shares? B) Suppose Sally is aiming to achieve a return of 8.5% on her funds invested in a portfolio consisting of these two shares. How much of her funds should be invested in each of these shares to achieve this return? C) What is the beta of the resultant portfolio? D) Would you support Sally's investment strategy?

Answer 1

(A) To calculate the Expected return of the each share we use CAPM (Capital Asset Pricing Model)

CAPM = R_f + (E(R)_m - R_f) * Beta

R_f = Risk free rate = 1.8%

E(R)_m =Expected Return of Market = 5.2%

Beta = Skenes = 1.4 and Torrens = 0.8

Now in case of Skenes

= 1.8%+(5.2%-1.8%)*1.4

= 6.56% Expected Return

For Torrens

= 1.8+(5.2%-1.8%)*0.8

= 4.52% Expected Return

(B) suppose he wants to earn a return of 8.5% so, he has to invest

(Percent of total fund *Expected Return of share Skenes)+(Percent of total fund *Expected Return of share Torrens)

= (0.9*6.56)+(0.1*4.52)

= 0.226+8.075= 8.301% means 90% in Skenes and 10% in Torrens

now here we have invested 90% of fund in skenes even than we can not achieve 8.5% target the main reason behind is low Expected return on the Torrens share.

To achieve 8.5% portfolio target we have 100% invest in the Skenes.

(C) Beta of the Portfolio =

(weight of investment * Beta of share Skenes)+(Weight of Investment * Beta of share Torrnes)

(0.9*1.4) + (0.1*0.8) = 1.34 Portfolio Beta.

(D) No, I don't support sally investment because she are not able diversify her risk as per her required return on the portfolio and she also goes with high beta which also not good.