Reference no: EM132383337
Part A - Portfolio returns
Analysts are pondering on the future of the Australian economy because of its potential impact on their portfolios. The manager of your team at the corporation you are working for notes that the risk free rate of return in Australia has reached a record low of 1.28% and the expected return of the share market index is 6.49%. The executive team wants to know whether any of these 3 companies represents an attractive investment. The current return data and their betas are given in Table 1.
Company
|
Beta
|
Actual return
|
Flight Centre
|
0.80
|
7.00%
|
Gooroo Ventures
|
1.00
|
7.50%
|
ANZ Bank
|
1.20
|
7.23%
|
The team will be seeking your opinion on whether to buy a stock, so you will need to be able to determine when a stock is overvalued or undervalued, as well as understand what is meant by the beta of a stock.
In addition to identifying stocks that will generate value, you will be expected to understand the concepts of risk and returns. Remember that the weight of stocks in a portfolio could be varied. Remember that, the risk of a portfolio of two stocks with equal weights will be different from the risk of a portfolio with unequal weights and the same is applicable to returns. The case of calculating the returns of a portfolio is different from calculating the risk of the same portfolio because of the effects of the variances and covariances. In the variance-covariance matrix below, you have been given three stocks, Flight Centre, Gooroo Ventures and ANZ bank. The variances are across the diagonals. Note: that the square root of variance is standard deviation. In this case, the standard deviation of flight centre is the square root of 0.2511 = 0.5010. The covariances are 0.7523 (Flight Centre and Gooroo Ventures) and 0.1753 (Flight Centre and ANZ).
Variance - covariance matrix
|
Flight centre
|
Gooroo Ventures
|
ANZ
|
Flight centre
|
0.2511
|
-
|
-
|
Gooroo Ventures
|
0.7523
|
0.6421
|
-
|
ANZ
|
0.1753
|
0.0135
|
0.8101
|
Supervisor's advice: Your supervisor has notified you that the team leader is likely to ask you about the returns of the three-stock portfolio. However, he is not sure whether he will assume equal weights or not. He has also asked about the risk of each pair of stocks if they were equally weighted. As you know, Portland has $150 million invested in these three stocks and so the actual monetary value of the returns will be of interest. However, he is known to vary the weights of their returns and their risks. On previous occasions he has asked for the returns of a two stock portfolio, as well as the entire portfolio. He will also be interested in the risk of a two-stock portfolio. You do not know which pair of stocks he is going to be interested in. The most vital question he is known to ask is the trade-off between risk and return of any portfolio of two stocks. It may also be a good idea that you prepare yourself to explain your choices based on the correlation between the two stocks and the coefficient of variation.
Your supervisor also advised you to lay out your work in Excel to make your presentation easier. Therefore, make sure you set up the calculations in Excel so that you can change the covariance and immediately see the impact on portfolio risk. You can set it up based on the data for one pair of stocks and change the data for the next pair.
Part B - CBA technology investment
Technology is revolutionizing the finance industry. In view of this, the Commonwealth Bank of Australia has decided to invest heavily in technological infrastructure across their banking operations. One of such technologies will cost the bank $30 million in cash and it will have associated cash flows over the next 10 years.
The benefits of these business improvements will fetch $20 million in the first year. However, the benefits will reduce at the rate of 5% annually from the second year as competitors adopt the same technology. Similarly, because highly skilled professionals will need to service the systems, maintenance will be high. So, it is expected that such expenses will cost $10 million in year one and it will reduce at the rate of 3% in subsequent years. The depreciation is $3 million and is constant throughout the project's life cycle. Corporate tax rate of 30% is applicable and the cost of capital for the bank is 5.27%. Management has decided to allocate $15 million in working capital at the commencement of the project. It is anticipated that the initial cash outlay for the investment will commence in the year 2020 (year 0) and will end in 2030 and all the working capital will be returned at the end of the life of the project.
According to your supervisor, management prefers the use of NPV and IRR in analysing projects. Now is the time for you to prove yourself as a graduate analyst in the team.