# Project Selection and Portfolio Risk Question 1: (marks 6) Your company has 4 projects A, B, C and..

Project Selection and Portfolio Risk

Question 1: (marks 6) Your company has 4 projects A, B, C and D. The returns generating by these projects are as follows:

.          Project(s)

Interest (return) earnings

A

11.56% per annum compounding annually

B

12% per annum compounding monthly

C

5% per semi-annual compounding monthly

D

3.26% per quarter compounding annually

Each of the project has 10 years of life. The initial investment for each of the project is also same \$100,000 each.

(i)  Your company management has asked you to select only one out of the four projects available, which one would you select? Show your calculation and justification of selection.

(ii)  Consider an alternative situation. Your company management has setup a minimum acceptance criteria for any new project selection. Such minimum acceptance criteria or required rate of return is set up at 12.5%. The management has asked you to select all projects generating return higher than the required rate of return (12.5%).

Question 2: (marks 6) Your company has another 4 projects E, F, G and H for investment. The company needs to borrow to finance these projects. Other details of the projects are as follows:

Project(s)

Key features

E

The required investment for the project is \$600,000, 20% is paid off as a down payment. The remaining amount is borrowed at an interest rate of 6% per annum. The monthly loan repayment instalment is decided as \$6,000 per month.

F

The required investment for the project is \$560,000, 10% is paid off as a down payment. The remaining amount is borrowed at an interest rate of 4.2% per annum. The monthly loan repayment instalment is decided as \$5,800 per month.

G

The required investment for the project is \$960,000, 40% is paid off as a down payment. The remaining amount is borrowed at an interest rate of 6.2% per annum. The monthly loan repayment instalment is decided as \$8,800 per month.

H

The required investment for the project is \$542,000. The entire amount is borrowed at an interest rate of 5.6% per annum. The monthly loan repayment instalment is decided as \$7,100 per month.

(i) Currently your company has access to sufficient funds and can borrow any amount required. The current liquidity position also suggest the company is not concerned about the monthly loan repayment obligations. Your top management has instructed you to pick the project with shortest loan repayment periods. Show your calculation and justification of selection.

Question 3: (marks 10)

You are the portfolio manager for a managed fund company. Currently you have limited funds available. Opportunity cost of your fund is 12%. There are three stocks (A, B and C) available in the market, you however need only one more stock to complete your portfolio. Few of the key features of the three stocks are as follows:

Stock A has been paying annual dividend of \$8.56 p.a. in last few years and is expected to keep the same dividend in the foreseeable future;

Stock B has paid \$6.23 annual dividend in the current year and is expected to grow at a constant rate of 4% p.a. in the foreseeable future;

Stock C has paid \$6 annual dividend in the current year and is expected to grow at 9% p.a. for the first five years and remain constant thereafter.

(i) You have approached a broker to buy a share. He is offering all the shares (A, B and C) at the same price of \$80 each. Explain your stock selection with relevant calculations.

As part of your job you have a portfolio comprising \$325,000 investment in Stock D and \$175,000 investment in Stock E, the correlation coefficient between stock D and E is 0.15.

(ii)  Rank stock D and E in terms of their return risk and return performance

(iii)  How does combining stock D and E in a portfolio impact the risk?

(iv)  How much the portfolio risk changes if the correlation between the securities changed to -0.89  and +0.95. Calculate, Compare and comment on the portfolio risk under 3 different correlation values (i.e. 0.15, -0.89 and +0.95) and its implication on risk diversifications.

Stock D

Stock E

Expected return [E(R)]

14%

18%

Standard Deviation

16%

24%