1

PORTFOLIO MANAGEMENT
ANALYSIS OF RISK AND RETURN
One of the main functions of finance manager of company is to invest the surplus available
fund in different type of securities. The sum total of all securities is referred as portfolio.
Under the function of managing portfolio a number of securities are selected out of varieties
of available securities. Each security has its own feature in term of return and risk attached to
it.
Portfolio Management is the process of selecting a bundle of securities that will provide the
company maximum return for a given level of risk or alternatively ensure minimum risk for
a given level of return.
Return comprises the income which, is in the form of dividend or interest and the capital
gain (loss). Return is calculated with the help of wealth ratio as follows:

(𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑆𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠 𝑎𝑡 𝑡ℎ𝑒 𝑒𝑛𝑑 𝑜𝑓 𝑦𝑒𝑎𝑟−𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑆𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠 𝑎𝑡 𝑡ℎ𝑒 𝑏𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔

𝑜𝑓 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟+𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑔𝑎𝑖𝑛
Return =
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑆𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠 𝑎𝑡 𝑡ℎ𝑒 𝑏𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑜𝑓 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟

Example 1: An asset can be purchased for Rs. 8,00,000 today and will have a value of Rs.
9,00,000 in one year. During the year, the asset will generate cash payments to the holder of
Rs. 50,000. What is the expected return on the investment?

9,00,000−8,00,000+50,000
Return = = 18.75%
8,00,000

Example 2: A regional stock exchange on January 1st had a total market value for all stocks
of Rs. 25 million. During the year, the stocks are expected to pay dividends of Rs. 1.5
million. The value of the stocks by next year is expected to be Rs. 28.5 million. What will be
the market rate of return for the year?

28.5 −25 +1.5

Return = = 20%
25

Risk refer to the possibility that the expected return may not materialize. There may be loss
of capital, i.e. investment has to be sold for an amount less than paid for it. There may be no
income from investment or the income may be less than the expected. The natural query is
“Why the investors go for risky investments”? The answer is that the desire for higher return
entices them to go for risky investments.
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Advanced Financial Management
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QUESTION NO.-1 A Ltd. never pays dividend. Its equity share is currently selling at Rs. 25.
Using the following data, find the expected return and standard deviation of expected returns
of share of A Ltd.
Price of equity share after 1 year (Rs.) Profitability of the price
20 .10
30 .20
40 .40
50 .20
60 .10

QUESTION NO.-2 (NOV-2005 ICAI) Following information is available in respect of

dividend, market price and market condition after one year.
Market condition Probability Market Price Dividend per share
Rs. Rs.
Good 0.25 115 9
Normal 0.50 107 5
Bad 0.25 97 3
The existing market price of an equity share is Rs. 106 (F.V. Re. 1), which is cum 10% bonus
debenture of Rs. 6 each, per share. M/s X Finance Company Ltd. has offered the buy-back of
debentures at face value.
Find out the expected return and variability of returns of the equity shares.
QUESTION NO.-3 LG, a appliances company has the following dividend per share and the
market price per share for the period 1995-2000:
Year Dividend per share Market price
1995 1.53 31.25
1996 1.53 20.75
1997 1.53 30.88
1998 2.00 67.00
1999 2.00 100.00
2000 3.00 154.00
Calculate the annual rate of return for last 5 years. Also calculate the risk of share.
Decision criteria for selecting one out of various securities

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(a) If expected returns from various securities are same but their standard deviations are
different then security with lower standard deviation should be preferred.
(b) If standard deviation from various securities are same but their expected returns are
different then security with higher expected returns should be preferred.
(c) If expected returns and standard deviations of various securities are different then
security with lower co-efficient of variation should be preferred.
QUESTION NO.-4 Calculate expected return and standard deviation of the following two
investments A and B. The economic predictions are:-
Climate Probability Returns from A% Return from B%
Expansion 0.3 25 40
Stable 0.5 20 10
Recession 0.2 15 (-)20
Which security will be preferred by investor?
QUESTION NO.-5 You have estimated the probability distribution of expected future return
for Stocks.
Stock X Stock Y
Probability Return Probability Return
0.1 -10% 0.2 2%
0.2 10 0.2 7
0.4 15 0.3 12
0.2 20 0.2 15
0.1 40 0.1 16
(a) What are the expected rate of return for Stock X and Stock Y?
(b) What is the standard deviation of expected returns for Stock X and Stock Y?
(c) Which stock would you consider to be riskier?
QUESTION NO.-6 The data for three securities X, Y and Z are as follows:
Securities Likely return Standard deviation
X 15% 0.20
Y 15% 0.19
Z 20% 0.24

Does anyone security dominates another? Which type of investor prefers security Z?

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Advanced Financial Management
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QUESTION NO.-7 Following is data regarding six securities:

A B C D E F
Return (%) 8 8 12 4 9 8
Return (%) 4 5 12 4 5 6
(Standard Deviation)
i. Assuming three will have to be selected, state which ones will be picked.
ii. Assuming perfect positive correlation, show whether it is preferable to invest 75% in
security A and 25% in security C or to invest 100% in E.
QUESTION NO.-8 Following is data regarding six securities:
A B C D E F
Return (%) 10 10 15 5 11 10
Return (%) 5 6 13 5 6 7
(Standard Deviation)
i. Assuming three will have to be selected, state which ones will be picked.
ii. Assuming perfect positive correlation, show whether it is preferable to invest 80% in
security A and 20% in security C or to invest 100% in E.
QUESTION NO.-9 An aggressive security promises an expected return of 16% with a
possible volatility (standard deviation) of 20%. On the other hand, a conservative security
promises an expected return of 13% and volatility of 15%.
(a) Which security would you like to invest in?
(b) Assuming you can borrow money at risk free rate of 10%, which security you would
invest your money in?
(c) Would you consider both securities if you could lend or borrow money at 10%?
QUESTION NO.-10
(a)
Portfolio A B C D E F G H
Expected return(r) % 10 12.5 15 16 17 18 14 20
Standard deviation(σ) 23 21 25 29 29 32 35 45

(b) Five of these portfolios are efficient, and three are not. Which are inefficient ones?
(a) Suppose you can also borrow and lend at an interest rate of 12%. Which of the above
Portfolio’s is best?

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(b) Suppose you are prepared to tolerate a standard deviation of 25%. What is the maximum
expected return that you can achieve if you cannot borrow or lend?
(c) What is your optimal strategy if you can borrow or lend at 12% and are prepared to
tolerate a standard deviation of 25%? What is the maximum expected return that you can
achieve?

QUESTION NO.-11 You are able to both borrow and lend at the risk-free rate of 9%. The
market portfolio of securities has an expected return of 15% and a standard deviation of 21%.
Determine the expected return and standard deviations of the following portfolios:
(a) All wealth is invested in the risk-free asset.
(b) All wealth is invested in the market portfolio.
(c) One third is invested in the risk-free asset and two thirds in the market portfolio.
(d) All wealth is invested in the market portfolio. Furthermore, you borrow an additional
one third of your wealth to invest in the market portfolio.
QUESTION NO.-12 If the risk-free return is 10% and the expected return on BSE index
18% (and risk measurement by standard deviation is 5%), how would you construct an
efficient portfolio to produce a 16% expected return and what would be its risk?
Suppose that you have personal funds of Rs. 1,00,000 to invest, how would you
construct a portfolio giving an expected return of 20% and what would be its risk?

QUESTION NO.-13 Consider the following information:

Investor Investment Objectives
A  Earn a return of 18%
 Can assume relevant risk for 18% return
B  Can assume a risk upto a variance in return of 250%

Further it is gathered that

Risk Free Interest Rf = 7% Return on Market portfolio, Rm = 15%
Standard Deviation in the return on Market portfolio, σm = 20%
You are required to find
(a) Risk level (Standard Deviation) of portfolio constructed by investor A.
(b) Expected level of return earned by the portfolio constructed by investor B.

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Advanced Financial Management
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QUESTION NO.-14 Mr. X is to invest his funds in two securities, P and Q. The relevant
information is as follows:
P Q
Expected Return 12% 20%
Standard deviation of return 10% 18%
Coefficient of correlation, r, between P and Q = 15
He has decided to consider only five portfolios of P and Q as follows:
(i) All funds invested in P
(ii) 50% of funds in each of P and Q
(iii) 75% funds in P and 25% in Q
(iv) 25% funds in P and 75% in Q
(v) All funds invested in Q
Find out:
(a) Expected rate under different portfolios
(b) Risk factor associated with these portfolios
(c) Which portfolio is best for him from the point of risk, and
(d) Which portfolio is best for him from the point of view of return.
QUESTION NO.-15 Returns on shares of X Ltd. and Y Ltd. for the past three years are as
under: X Y
Year 1 9% 6%
Year 2 12% 30%
Year 3 18% 18%
(i) Find expected return & standard deviation of securities X and Y.
(ii) Find the covariance and coefficient of correlation between X and Y.
QUESTION NO.-16 Returns on shares of P Ltd. and Q Ltd. for the past two years are as
under:
P Q
Year 2000 11% 20%
Year 2001 17% 8%
Calculate the following:
(i) Find out standard deviation of each stock.
(ii) Find the covariance and coefficient of correlation between P and Q.
(iii)If P and Q stock is invested in the ratio of 2:1, what is the portfolio risk.

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(iii)If the ratio of investment in P and Q is 1:1 then what is the overall portfolio risk and
why it has gone up.
QUESTION NO.-17 Mr. Sharma owns a portfolio of two securities with the following
expected returns, standard deviations and weights:
Security X Y
Expected Return (%) 12 15
Standard deviation (%) 15 20
Weight 0.40 0.60
What are the maximum and minimum portfolio standard deviations for varying levels of
correlation between two securities?
QUESTION NO.-18 L Ltd. and M Ltd. have the following risk and return estimates.
RL = 20% RM = 22%
σL = 15% σM = 18%
(Correlation Coefficient) = RLM = -1
Calculate the proportion of investment in L Ltd. and M Ltd. to minimise the risk of portfolio
and Compute the risk and return.
QUESTION NO.-19 Return and risk on shares P and Q are as under:
Expected Return Standard deviation
Stock P 16% 25%
Stock Q 18% 30%
What is the expected return of a portfolio is constructed to drive the standard deviation of
portfolio return to zero?
QUESTION NO.-20 Return and risk on shares A and B are as under:
Expected Return Standard deviation
Stock A 15% 20%
Stock B 25% 50%
(i) Calculate the expected return on portfolio if the two stocks are equally weighted.
(ii) How would different correlations between the returns of the component stocks impact on
portfolio risk? Calculate the SD when Correlations (A, B) is +1.0, 0, and -1.0.
QUESTION NO.-21 P Ltd. and Q Ltd. have low positive correlation coefficient of +0.5.
Their respective risk and return profile is as under:
Rp = 10% Rq =15%
σp = 20% σq = 25%

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Compute the portfolio of P & Q to minimize risk and compute the risk and return.
QUESTION NO.-22 Europium Ltd. has been specially formed to undertake two investment
opportunities. The risk and return characteristics of the two projects are shown below:
A B
Expected return 12% 20%
Risk 3% 7%
Europium plans to invest 80% of its available funds in Project A and 20% in B. The directors
believe that the correlation co-efficient between the returns of the projects is +1.0.
(i) Calculate the return and risk from the proposed portfolio of Project A and B.
(ii) Suppose the correlation co-efficient between A and B was -1. How should the company
invest its funds in order to obtain zero risk portfolio.
QUESTION NO.-23 An investor holds two equity shares x and y in equal proportion with
the following risk and return characteristics:
X Y
Expected Return (%) 24 19
Standard deviation (%) 28 23
The returns of these securities have a positive correlation of 0.6 You are required to calculate
the portfolio return and risk. Further, suppose that the investor wants to reduce the portfolio
risk to 15 percent. How much should the correlation coefficient be to bring the portfolio risk
to the desired level?
QUESTION NO.-24 Calculate expected return, standard deviation, covariance and
correlation of the following two investments A and B. The economic predictions are:-
Economic Climate Probability Return from A% Return from B%
Recession 0.2 10 06
Stable 0.5 14 15
Expansion 0.3 20 11
1.0
Compute return and risk of all the following portfolios base on correlation covariance.
Investment A B
(i) Proportion 0.5 0.5
(ii) Proportion 0.7 0.3
(iii) Proportion 0.2 0.8

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Advanced Financial Management
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QUESTION NO.-25 XYZ Ltd. wishes to buy Rs. 1 million of shares in each of two
companies from a choice of three companies that it might wish to acquire at some future date.
The companies are in different industries. Historic five year data on the risk and return of the
three companies are shown in below:
Average annual returns Standard deviation of returns
P Ltd. 11% 17%
Q Ltd. 20% 29%
R Ltd. 14% 21%

Correlation coefficient between returns

P Ltd and Q Ltd. 0.00
Q Ltd. and R Ltd. 0.40
P Ltd. and R Ltd. 0.62
An adviser to XYZ Ltd. has suggested that the decision about which shares to buy should be
based upon selecting the most efficient portfolio of two shares.
Estimate which of the possible portfolios is the most efficient.
QUESTION NO.-25 A portfolio consists of three securities P, Q and R with the parameters.
P Q R Correlation
Coefficient
Expected return (%) 25 22 20
Standard deviation (%) 30 26 24
Correlation Coefficient
PQ -0.5
QR + 0.4
PR + 0.6

If the securities are equally weighted, how much is the risk and return of the portfolio of these
three securities?
QUESTION NO.-27 A portfolio consist of 3 securities. 1, 2, and 3. the proportions of these
securities are w1 = 0.3, w2 = 0.5 and w3 = 0.2. The standard deviations of returns on these
securities (in percentage terms) are SD1=6, SD2=9 and Sd3=10. the correlation coefficients
among security returns are r12 = 0.4, r13 =0.6, r23= 0.7. What is the standard deviation of
portfolio return?

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Advanced Financial Management
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QUESTION NO.-28: A portfolio consists of 4 securities, 1, 2, 3 and 4. The proportions of

these securities are: x1=0.2, x2=0.3, x3=0.4, x4=0.1. The standard deviation of returns on these
securities (in percentage terms) are: Ϭ1=4, Ϭ2=8, Ϭ3= 20, Ϭ4= 10. the correlation coefficients
are: are r12 = 0.3, r13 =0.5, r13= 0.2, are r14 = 0.6, r24 =0.8 and r34= 0.4.
QUESTION NO.-29 The results of four portfolio managers are as follows:
Portfolio Manager Average Return (%) Beta
A 13 0.80
B 14 1.05
C 17 1.25
D 13 0.90
Select the manager will best performance if rate of risk free return is 8% & return on market
portfolio is 14%.
QUESTION NO.-30 The following data relating to two securities, A and B.
A B
Expected Return 22% 17%
Beta Factor 1.5 0.7
Assume: IRF = 10, and RM = 18%
Find out whether the securities, A and B are correctly priced?
QUESTION NO.-31 The following information is available in respect of security X and Y.
Security Beta Expected Return
X 1.8 22.00%
Y 1.6 20.40%
If the risk free rate is 7%, are these securities correctly priced? What would the risk free rate
has to be if they are correctly priced?
QUESTION NO.-32 A Ltd. has an expected return of 22% and Standard deviation of 40%.
B Ltd. has an expected return of 24% and Standard deviation of 38%. A Ltd. has a beta of
0.86 and B Ltd. a beta of 1.24. The correlation coefficient between the return of A Ltd. and B
Ltd. is 0.72. The Standard deviation of the market return is 20%. Suggest:
(i) Is investing in B Ltd. better than investing in A Ltd.?
(ii) If you invest 30% in B Ltd. and 70% in A Ltd., what is your expected rate of return and
portfolio Standard deviation?
(iii)What is market portfolios expected rate of return and how much is the risk-free rate?
(iv) What is the beta of Portfolio if A Ltd's weight is 70% and B. Ltd's weight is 30%?

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Advanced Financial Management
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QUESTION NO.-33 From the following information calculate the expected rate of return of
a portfolio.
Risk free rate of interest 5.2%
Expected return of market portfolio 9.8%
Standard deviation of an asset 3.0%
Market Standard deviation 2.2%
Co-relation Co-efficient of portfolio with market .8

QUESTION NO.-34 (MAY 06) he distribution of return of security 'F' and the market
portfolio 'P' is given below:
Probability Return%
F P
0.30 30 -10
0.40 20 20
0.30 0 30
You are required to calculate the expected return of security 'F' and the market portfolio 'P',
the covariance between the market portfolio and security and beta for the security.
QUESTION NO.-35 Following information concerning the return on the shares of C Ltd.
and on the market portfolio.
Probability Return C Ltd. Return market
0.2 15% 10%
0.4 14% 16%
0.4 26% 24%
Calculate the beta. Is C Ltd. efficiently priced according to the CAPM if the current risk-free
interest rate is 9 per cent? Also calculate systematic risk and unsystematic risk.
QUESTION NO.-36
Following data regarding the rates of return available on potential project and the market.
State Probability Return Market Return Project
Deep recession 0.05 (20%) (30%)
Mild recession 0.25 10 5
Average 0.35 15 20
Mild boom 0.20 20 25
Strong boom 0.15 25 30

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Further, financial analysis estimate the risk-free rate is 8%

(a) What are the expected rates of return on the market and the project?
(b) What is the market's beta and project's beta?
(c) What is the required rate of return on the project according to the CAPM?
(d) Should the project be accepted? Also calculate systematic risk and unsystematic risk.
QUESTION NO.-37 (NOV-04 ICAI) Given below is information of market rates of Returns
and Data from two Companies A and B:
Year 2002 Year 2003 Year 2004
Market (%) 12.0 11.0 9.0
Company A (%) 13.0 11.5 9.8
Company B (%) 11.0 10.5 9.5
Required:
(i) Determine the beta coefficient of the Shares of Company A and Company B.
(ii) Distinguish between 'Systematic risk' and 'Unsystematic risk'.
QUESTION NO.-38 Finance of Manager of Piquet Ltd., has following information and
seeks your advice in determining the Beta value of the company's stock. The company
expects that considering the current market price, the equity share holders should get a return
of at least 15.50% while the current return on the market is 12%. RBI has closed the latest
auction for Rs. 500 crores of 182 days T-bills for the lowest bid of 4.3% although there were
bidders at a higher rate of 4.6% also, for lots of less than Rs. 10 crores.
QUESTION NO.-39 You have purchased the following data from a merchant bank:
Company Forecast total equity Standard deviation of Covariance with
return (%) total equity return (%) market return (%)
A Ltd. 16 6.3 32
B Ltd. 12 4.8 19
C Ltd. 14 4.7 24
D Ltd. 19 6.9 43
The market return and the market standard deviation are 14.5% and 5% respectively and the
risk free rate is 6%. Returns and all other data relate to a one year period.

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QUESTION NO.-40 The Vantage Investment Fund has a total investment of $400 million in
the five stocks:
Stock Investment (in million) Stock's Beta Coefficient
A $120 0.5
B 100 2.0
C 60 4.0
D 80 1.0
E 40 3.0
The beta coefficient for a fund such as this can be found as a weighted average of the betas of
the fund's investments. The current risk-free rate is 7%, and the market return has the
following estimated probability distribution for the next year.
Probability Market Return
0.1 8%
0.2 10
0.4 12
0.2 14
0.1 16
Compute the required rate of return on the Vantage Investment Fund.
Suppose management receives a proposal to buy a new stock. The investment needed to take
a position in the stock is $50 million, it will have an expected return of 6%; and its estimated
beta coefficient is 2.5. Should the new stock be purchased? At what expected rate of
return would management be indifferent to purchasing the stock?
QUESTION NO.-41 The Beta Coefficient of Target Ltd. is 1.4. The company has been
maintaining 8% rate of growth in dividends and earnings. The last dividend paid was Rs. 4
per share. Return on Government securities is 10%. Return on market portfolio is 15%. The
current market price of one share of Target Ltd. is Rs. 36.
(i) What will be the equilibrium price per share of Target Ltd?
(ii) Would you advise purchasing the share?

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QUESTION NO.-42 An investor is holding 1,000 shares of Fatlass company. Presently the
rate of dividend being paid by the company is Rs. 2 per share and the share is being sold at
Rs. 25 per share in the market. However, several factors are likely to change during the
course of the year as indicated below:
Existing Revised
Risk free rate 12% 10%
Market risk premium 6% 4%
Beta Value 1.4 1.25
Expected growth rate 5% 9%
In view of the above factors whether the investor should hold or sell the shares?
QUESTION NO.-43 The risk free rate of return Rf is 9%. The expected rate of return on the
market index Rm is 13%. The expected rate of growth for the dividend of firm A is 7%. The
last dividend paid on the equity stock of firm A was Rs. 2.00. Beta of firm A's equity stock is
1.2.
(a) What is the equilibrium price of the equity stock of firm A?
(b) How would the equilibrium price change under each of the following conditions, when -
(1) the inflation premium increases by 2%.
(2) the expected growth rate increased by 3%; and
(3) the beta of A's security rises to 1.3?

QUESTION NO.-44 The required return on the market portfolio is 12%. The beta of stock X
is 2. The required return on the stock is 18 percent. The expected dividend growth on stock is
5%. The price per share of stock X is Rs. 30. What is the expected dividend per share of stock
X next year? What will be the combined effect of the following on the price per share of
stock X?
(a) The inflation premium increases by 2 percent.
(b) The decrease in the degree of risk-aversion reduces the differential between the return on
market portfolio and the risk-free return by one-third.
(c) The expected growth rate of dividend on stock X decreases to 4 percent.
(d) The beta of stock X falls to 1.8.

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QUESTION NO.-45 As an investment manager you are given the following information
A Investment in equity Initial price Dividends Market price at Beta risk factor
Share of Rs. Rs. the end of year
Cement Ltd. 25 2 50 0.8
Steel Ltd. 35 2 60 0.7
Liquor Ltd. 45 2 135 0.5
B Government of India
Bonds 1,000 140 1,005 0.99
Risk free return may be taken at 14%

Calculate (i) Expected rate of return of portfolio in each using Capital Asset Pricing Model
(CAPM) (ii) Average return of the portfolio.
QUESTION NO.-46 Your client is holding the following securities:
Securities Cost Dividends Market price Beta
Equity shares Rs. Rs. Rs. Rs.
Co. X 8,000 800 8,200 0.8
Co. Y 10,000 800 10,500 0.7
Co. Z 16,000 800 22,000 0.5
PSU Bonds 34,000 3,400 32,300 1.0
Assuming a Risk-free rate of 15%, calculate:
(a) Expected rate of return in each using the CAPM.
(b) Average return of the portfolio.

QUESTION NO.-47 Your client is holding the following securities:

Particulars of Cost Dividends/Interest Market Price Beta
Securities Rs. Rs. Rs.
Equity Shares:
Gold Ltd. 10,000 1,725 9,800 0.6
Silver Ltd. 15,000 1,000 16,200 0.8
Bronze Ltd. 14,000 700 20,000 0.6
GOI Bonds 36,000 3,600 34,500 1.0
Average return of the portfolio is 15.7% calculate:
(i) Expected rate of return in each, using the Capital Asset Pricing Model (CAPM)
(ii) Risk free rate of return.
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QUESTION NO.-48 The total market value of the equity of X Ltd. is Rs. 6 million and the
total value of its debt is Rs. 4 million. The beta value of the equity is estimated to be 1.5 and
the expected market risk premium is 10%. The risk-free rate of return is 8%.
(a) What is the required return on the X Ltd. equity?
(b) What is the beta of the company's existing portfolio of assets?
(c) Estimate the company's cost of capital.
(d) Estimate the discount rate for an expansion of the company's present business.
(e) If the company replaces Rs. 3 million debt with equity. Does the beta of the equity
change?
(f) What would the company cost of capital be now?
(g) If the company wishes to diversify into another industry with a beta value of 1.2, what
would be the required rate of return?
QUESTION NO.-49 Silvergreen Ltd. is a real-estate company. Market value of their debt is
Rs. 300 lacs. The company has 10,00,000 equity shares of Rs. 10 each, market price of which
is presently Rs. 40/-. Equity beta is 1.40. Market risk premium is 6%. RBI Bonds are quoted
at 6%.
(i) Required return on equity shares
(ii) Beta of assets
(iii)Cost of capital
(iv) Appropriate discount rate that the company should use for an expansion proposed
(v) The company is diversifying into pharmaceuticals. Average ungeared company in that
industry carries a beta of 1.50. What should be the expected return on this new venture?
QUESTION NO.-50 The average equity beta value for a group of similar companies in the
motor industry is 1.32; their average debt to equity ratio is 0.20. The debt-to-equity ratio of
Arden Motors is 0.30 while the risk-free rate of return is currently 12%. The market risk
premium can be assumed to be 90%.
(a) What is the required return on the assets of Arden Motors?
(b) What is the required return on the equity of Arden Motors?
QUESTION NO.-51 A Ltd. & B Ltd. are similar risk class company
A Ltd. B Ltd.
Debt beta 0.30 0.45
Debt equity ratio 0.50 0.80
Equity beta 1.50 ?

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QUESTION NO.-52 AE Ltd., and DE Ltd., are companies in the same risk class, paying
taxes at 35% and registering steady (no growth) earnings. An extract of financial statements
show that AE is an all-equity company, while DE is a geared company. Market value are in
equilibrium. Assume tax rate is 35% and debt beta is zero.

(Amounts/Rs. 000)
AE Ltd. DE Ltd.
Market value of equity 5,900 3,744
Market value of debt --- 3,556
Interest on debt at 7% --- 280
Surplus after tax PAT 650 468

If Equity Beta value for AE is 1 computer (i) Cost of Equity of DE, (ii) Market return for AE
and (iii) Beta value of DE.
QUESTION NO.-53 XYZ an all equity company has equity beta = 0.6, P/E Ratio = 5 and is
priced offer to return of 20%. It decides to buy back half of equity shares by borrowing equal
amount. Risk free rate is 10%. Assume Tax=NIL. Calculate:
(i) Beta of equity share after buy back.
(ii) The required rate and risk premium on equity before buy back.
(iii)The required rate and risk premium on equity after buy back.
(iv) The required return on debt.
(v) The percentage increase in E.P.S.
(vi) New price- earning ratio.
Assuming operating profit will remain same for perpetuity.

QUESTION NO.-54 Two companies are identical in all respects except capital structure.
One company AB Ltd. has a debt equity ratio of 1:4 and its equity has a beta value of 1.1.
The other company XY Ltd. has a debt equity ratio of 3:4. Income tax is 30%. Estimate beta
of XY Ltd. given the above.
QUESTION NO.-55 A Ltd. wants to diversify into shoe business. It found a comparable
shoe company with an equity beta 1.35 debt ratio of 0.72. The corporate tax is 35%. A Ltd.
has debt ratio for proposed show business 0.50. Calculate equity beta for new business.

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QUESTION NO.-56 Jodes and Gems finance their assets will 40% borrowed funds. Their
equity beta has a value of 1.25. risk free interest is 6%, and expected market risk premium is
3%. For strategic reasons, JG is promoting another company in the same line of business
(same risk class). What would be expectations from the new company of the investors in
equity, if it were no be entirely financed by equity funds and the tax rate stood at 34%.
QUESTION NO.-57 ABC Ltd., has an equity Beta of 1.40. It has a debt-equity mix of 30/70.
The company is changing the size and composition of its owned funds, so as to result in a
new debt-equity mix of 40/60. If the corporate tax rate is 30%, what would be the new equity
beta of the company, after the restructuring?
Present D/E 3:7
Equity beta value 1:40
New D/E 4:6
Tax rate 30%
QUESTION NO.-58 M/s. V Steels Limited is planning for a diversification project in
Automobile Sector. Its current equity beta is 1.2, whereas the automobile sector has 1.6.
Gearing of automobile sector is 30% debts, 70% equity. If expected market return is 25%,
risk free debt is 10% and taxation rate is taken as 30% and also that corporate debt is assumed
to be risk free.
Compute suitable discount rate under the following situations. (i) Project financed by equity
only, (ii) By 30% debt and 70% equity (iii) By 40% debt and 60% equity
QUESTION NO.-59 M/s. Reliance Industries Limited is planning for a diversification
project in I.T. Sector. Its current equity beta is 1.1, whereas the I.T. sector has 1.72. Gearing
of I.T. sector is 40% debts, 60% equity. If expected market return is 22%, risk free debt is
10% and taxation rate is taken as 35% and also that corporate debt is assumed to be risk free.
Compute suitable discount rate under the following situations. (i) Project financed by 50%
equity and 50% debt, (ii) By 20% debt and 80% equity (iii) By 70% debt and 30% equity

QUESTION NO.-60 M/s. Escort's Limited is planning for a diversification project in Paper
products. Its current equity beta is 1.75, whereas the Paper Industry has 2.68. Gearing of
Paper Industry is 40% debts, 60% equity and Beta corporate debt is 0.3. If expected market
return is 22%, risk free debt is 10% and taxation on rate is taken as 35%.
Compute suitable discount rate under the following situations. (i) Project financed by equity
only (ii) By 25% debt and 75% equity (iii) By 30% debt and 70% equity.

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QUESTION NO.-61 XYZ is at present engaged in production of sport shoes and has a debt
equity ratio of .80. its present cost of debt fund is 14% and it has a marginal tax rate of 60%.
The company is proposing to diversify to a new field of adhesives which is considerably
different from the present line of operations. XYZ Limited, is not well conversant with the
new field. The company is not aware of risk involved in area of adhesives but there exists
another company PQR, which is a representative company in adhesives. PQR is also a public
limited company whose shares are traded in the market. PQR has a debt to equity ratio of .25,
a beta equity of 1.15 and an effective tax rate is 40%.
a) Calculate the risk is involved for XYZ Limited if the company enters into the business of
adhesives.
b) In case risk free rate at present is 10% and expected return on market portfolio is 15%
what return XYZ Limited should require for the new business if it uses a CAPM approach
and XYZ employs same amount of leverage.
QUESTION NO.-62 Midland Industries has three operating divisions
Division Percentage of firm value
Food 50
Chemicals 30
Machine tools 20
The Finance Director wishes to estimate divisional costs of capital and has identified three
companies carrying out similar activities:
Equity beta Debt/equity
Amalgamated Foods 0.9 0.40
Studge Chemicals 1.2 0.25
Chunky Tools 1.4 0.50
(a) Estimate assets betas for each of Midland's divisions on the assumption that debt can be
regarded as risk free.
(b) If Midland's debt to equity ratio is 0.25 what is its equity beta?
(c) If the risk-free rate of return is 10% and the expected return on the market is 18%, what is
the cost of capital for each of Midland's divisions?
(d) How reliable do you consider the costs of capital calculated in (c)?

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QUESTION NO.-63 XYZ Ltd. is a 100% equity financed company with beta of 1.24, It is a
diversified company with three operating divisions - East, West and Central. The operating
characteristics of east are 50% more risky than west and central is 25% less risky than west.
West is having twice market value than that of East, while Central is having equal market
value than that of East. The market return is 24% and standard deviation is 16%. At present
the West division has started showing under performance, the management of XYZ Ltd.
planned to sell the West division and use the entire amount to purchase PQR Ltd. PQR Ltd. is
an all equity company and having similar market as of West division. PQR Ltd. has a revenue
sensitivity of 1.5 times that of West division of XYZ. and also PQR Ltd. has operating
gearing ratio of 1.8 current operating gearing ratio in west at 2.00.
Assume Risk free rate 11%, no synergistic benefits from disinvestment and acquisition and
taxation is to be ignored. Required to calculate:
(i) Assets beta for each division of XYZ Ltd.
(ii) Calculate assets beta for PQR Ltd.
(iii)Calculate assets beta for XYZ Ltd. after disinvestments and acquisition
(iv) Calculate the discount rate applicable to new investment project.

QUESTION NO.-64 Excellent Ltd. is a frozen food packaging company and is looking to
diversify its activities into the electronics business. The project it is considering has a return
of 18% and Excellent Ltd. is trying to decide whether the project should be accepted or not.
To help it decide it is going to use the CAPM The company has to find a proxy beta for the
project and has the following information on three companies in the electronics business:
(a) Superior Ltd.
Equity beta of 1.33. Financed by 50% debt and 50% equity.
(b) Admirable Ltd.
Admirable Ltd. has an equity beta of 1.30, but it has just taken on a totally unrelated
project accounting for 20% of the company's value, that has an asset beta of 1.4. The
company financed by 40% debt and 60% equity.
(c) Meritorious Ltd. Equity beta of 1.05. Financed by 35% debt and 65% equity.
Assume tax rate 35%.

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QUESTION NO.-65 Arona and Zebra have been paying a dividend of Rs. 32 each year, to
their shareholders. Beta coefficient of these two companies are 1.25 and 1.4 respectively. If
the risk free return is 6% and market return is 10% what is the prediction about the share-
price of these two entities? Ignore growth rate.
QUESTION NO.-66 An all-equity company is expected to generate Rs. 48.5 million in
dividends per annum in perpetuity and has a beta coefficient of 1.85. Another company, also
all-equity, is expected to generate Rs. 37.8 million in perpetuity and has a beta coefficient of
0.68. The risk-free rate of return is 7.5% and the expected return on the market is 13.8%.
(a) If the two firms were to merge, and if no scale economies or managerial synergies were
expected from the merger, what would be the value of the combined firm?
(b) If the merger of the two firms were to result in managerial synergies that are expected to
increase the annual dividends of the combined firm by Rs. 3.85 million but to leave its
systematic risk unaltered, what would be the value of the combined firm?

QUESTION NO.-67 Batliboi Ltd. has been enjoying a substantial net cash inflow, and until
the surplus funds are needed to meet tax and dividend payments and to finance further capital
expenditure in several months time, they have been invested in a small portfolio of short-term
equity investments.
Details of the portfolio, which consists of shares in four UK listed companies, are as follows:
Company No. of Beta equity Market price Latest Expected return
Shares held co-efficient per share dividend on equity in the
(Rs.) Yield % next year %
LG Ltd. 60000 1.16 4.29 6.10 19.50
ITC Ltd. 80000 2.28 2.92 3.40 24.00
L&T Ltd. 100000 0.90 2.17 5.70 17.50
MGF Ltd. 125000 1.50 3.14 3.30 23.00
The current market return is 19% a year and the risk free rate is 11% a year. Required:
On the basis of the data given, calculate the return of Batliboi Ltd.'s short term investment
portfolio relative to that of the market.
(2) Recommend, whether Batliboi Ltd. should change the composition of its portfolio.

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QUESTION NO.-68 LG is a manufacturing company whose shares are listed on the Delhi
Stock Exchange. It is expecting to have surplus cash resources available for at least 12
months. The board has decided to develop an investment portfolio of marketable securities.
The company's financial advisers have recommended four securities for the board to
consider. These are as follows:
Security 1 regularly traded shares in a medium - sized Indian company. The equity beta is
quoted as 1.2.
Security 2 shares in a relatively small but rapidly growing Indian company in a high -
technology industry. The shares have an equity beta of 1.6.
Security 3 shares in an British bank which are listed on London International Stock exchange
but not in India. They are currently quoted at Pound 25.50. An equity beta is unavailable, but
LG's stockbroker estimates that the expected rate of return on the shares is 12% per annum.
Security 4 short - dated government bonds.
The expected return on Treasury Bills is 5% per year, and that of the market of 12%. LG's
equity beta is 0.8 and this is not expected to change in the foreseeable future. The board can
invest in one or more of these securities in any proportion.
Calculate the risk and expected return of the investment portfolio, assuming 30% of
available funds is invested in each of securities 1 and 2 and 20% in each of securities 3 and 4.
QUESTION NO.-69 You have invested in four securities (A, B, C and D), the following
sums: A:10,000, B: 20,000; C: 16,000; D: 14,000.
The Beta values of the securities are 0.80, 1.20, 1.40 and 1.75 respectively. If the risk free
return is 4.25% and the market return is 11%, what is the expected return on the portfolio? If
you encash your investment in security B and invest the funds in RBI Bonds yielding a return
of 4.25%, what is the Beta value of the portfolio and its expected return?
QUESTION NO.-70 4 Stocks P, Q, R and S have shown the following returns over a period
of six years:
1 2 3 4 5 6
P 10% 12% -8% 15% -2% 20%
Q 8% 4% 15% 12% 10% 6%
R 7% 8% 12% 9% 6% 12%
S 9% 9% 11% 4% 8% 16%
Calculate the return on:
A. portfolio of one stock at a time B. portfolio of two stocks at a time

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C. portfolio of three stock at a time D. a portfolio of all the four stocks

Assume equiproportional investment.

QUESTION NO.-71 From the following information, show the efficient frontier.
Security Expected Return (%) Risk (%)
A 15 13
B 13 8
C 10 4
D 8 3
E 5 4
F 5 9
G 10 12
H 10 9
I 7 8
J 9 7

QUESTION NO.-72 The rates of return on the security of company Y and market portfolio
for 10 periods are given below:
Period Return on security Y (%) Return on Market Portfolio (%)
1 20 22
2 22 20
3 25 18
4 21 16
5 18 20
6 -5 08
7 17 -6
8 19 05
9 -7 6
10 20 11
What is the beta of security Y?
What is the characteristic line for security Y?

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QUESTION NO.-73 The market portfolio has a historically based expected return of 0.095
and a standard deviation of 0.035 during a period when risk-free assets yielded 0.025. The
0.06 risk premium is thought to be constant through time. Risk-less investments may now be
purchased to yield 0.08. A security has a standard deviation of 0.07 and a 0.75 correlation
with the market portfolio. The market portfolio is now expected to have a standard deviation
of 0.035.
Find the market's return-risk trade-off. Find the security beta.
Find the equilibrium required expected return of the security.

QUESTION NO.-74 An investor is considering to make an investment in the share of Divine

Home Company. The following are the attributes of five economic forces that influence the
return of Divine's share:
Factor Beta Expected Value Actual Value
GNP 1.95 6.00% 6.50%
Inflation 0.85 5.00% 5.75%
Interest rate 1.20 7.00% 8.00%
Stock market index 2.50 9.50% 11.50%
Industrial production 2.20 9.00% 10.00%
The risk-free (anticipated) rate of return on the Divine's share is 9%. How much is the total
return on the share?
Evaluation of Mutual Funds (Portfolio) Performance
There are three angels to measures the performance of mutual funds. These are (i) Jenson
Alpha (ii) Sharpe ratio measurement and (iii) Treynor ratio measurement
Jenson's Alpha
It measures the excess of expected return earned over the expected return under CAPM. If it
result into positive figure it means the given fund shows better performance and if it results
into negative figure it means the given fund shows worse performance.
Jenson's Alpha = Expected Return - [RF + Beta (RM - RF)]
= Expected Return - Return under CAPM
Sharpe Ratio
This is also known as reward to variability ratio. It measures the risk premium earned per unit
of total risk. Risk premium is excess of Expected Return over risk free return and total risk

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involved in funds is standard deviation of expected return from funds. When we compare
position of two or more funds, a fund with higher Sharpe Ratio gets better ranks.
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑅𝑒𝑡𝑢𝑟𝑛−𝑅𝐹
Sharpe Ratio = 𝑆𝐷

Treynor Ratio
This is also known as reward to volatility ratio. It measures the risk premium earned per unit
of systematic risk. Risk premium is excess of Expected Return over risk free return and
systematic risk is denoted by Beta. When we compare position of two or more funds, a fund
with higher Sharpe Ratio gets better rank.
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑅𝑒𝑡𝑢𝑟𝑛−𝑅𝐹
Treynor Ratio = 𝐵𝑒𝑡𝑎

Comparison between mutual funds

If mutual funds are of almost similar types, Jenson's Alpha is used for the comparison of their
performance.
If mutual funds as well diversified Treynor Ratio is used for the comparison of their
performance, because in such mutual funds, there is almost negligible unsystematic risk.
In case of other type of mutual funds Sharpe Ratio is used for the comparison of their
performance.
QUESTION NO.-75 The standard deviations, betas and average rates of return of several
managed portfolio are given below, along with the standard deviation and average rate of
return of the market index. The beta of the index is assumed to be 1. Further assume the T-
bills rate averaged 7% during the time period performance measurement. Compare these
funds on performance using the Sharpe, Treynor and Jensen measures.
Funds Average Return Std. Deviation Beta
A 0.15 0.25 1.25
B 0.12 0.30 0.75
C 0.10 0.20 1.00
RM 0.12 0.25 1.00

QUESTION NO.-76 The following are the data on Five mutual funds:
FUND RETURN STANDARD DEVIATION BETA
Dhan Raksha 16 8 1.50
Dhan Varsha 12 6 0.90

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Dhan vredhi 14 5 1.40

Dhan mitra 18 10 0.75
Dhan laheri 5 7 1.25
What is the reward-to-variability/volatility ratio and the ranking if the risk-free rate is 7%?
QUESTION NO.-77 You are running a portfolio management business and have assembled
the following portfolio for Client A.
Scrip Value Beta
Infosys Rs. 5 lakhs 1.21
Hind. Lever Rs. 8 lakhs 0.97
Reliance Rs. 5 lakhs 1.09
Tata Motors Rs. 2 lakhs 1.32
Your client insists that the portfolio should comprise the above 4 scrips alone and that each
scrip should be at least 10% of the total portfolio value. You project the Sensex which is
currently 4200 to move to 4500 by the end of 3 months and to 4800 by the end of 6 months?
(a) What will be the value of your portfolio at the end of 3 months and 6 months?
(b) What is the portfolio beta currently?
(c) What could you do to improve the portfolio performance given your view on the market?
(d) If you do take such action, what will the portfolio value be after 3 months and after 6
months?
(e) What will be the portfolio beta in such a case?
(f) At the end of 6 months, you believe that the bull market would have had its run and that
the Sensex will now start moving down to around 4600 levels at the end of 9 months from
now. How will you again restructure the portfolio at the end of 6 months from now?

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QUESTION NO.-78 (NOV-2005 ICAI) The Investment portfolio of a bank is as follows:

Government Bond Coupon Rate Purchase rate Durations
(F.V. Rs. 100 per Bond) (Years)
G.O.I. 2006 11.68 106.50 3.50
G.O.I. 2010 7.55 105.00 6.50
G.O.I. 2015 7.38 105.00 7.50
G.O.I. 2022 8.35 110.00 8.75
G.O.I. 2032 7.95 101.00 13.00
Face value of total investment if Rs. 5 crores in each Government Bond. Calculate actual
Investment in portfolio. What is suitable action to churn out investment portfolio in the
following scenario?
1. Interest rates are expected to lower by 25 basis points
2. Interest rates are expected to raise by 75 basis points
Also calculate the revised duration of investment portfolio in each scenario.

Compiled by Ram Chandra Khanal

Advanced Financial Management