Question

You have reviewed the characteristics and historical prices of two companies (A and B), and have estimated their relations to the wider market, detailed below:

	Company A	Company B
Current dividends per share (just paid)	$0.06	$0.40
Current Beta	1.3	1.5
Growth in dividends	4%	5%

Date	Share Price A	Share Price B
2016	$0.35	$4.13
2017	$0.42	$6.76
2018	$0.40	$5.23
2019	$0.52	$4.88

Other information:

• Current risk-free rate of return: 3% p.a.
• Current return on market portfolio: 11% p.a.

1. Calculate the expected return and standard deviation for share A and B.

2. Calculate the required return for share A and B, given their risk characteristics.

3. Calculate the intrinsic value of Company A’s and B’s shares. Based on your calculated intrinsic value, identify whether you would buy or sell the shares, using the 2019 share price for each share as a reference value. Provide justification for your decision.

4. Briefly explain, in your own words, what is likely to occur, in relation to the risk exposure of an investment portfolio, as an investor increases the number of investments in the investment portfolio.

Answer 1

Solution:

Required Return are calculated using CAPM model.

Intrisic value is calculated using Gordon Dividend Discount Model with constant growth rate P0 = D0 *(1+g)/(r-g) where r is the required return.

Excel solution with formulas is as under:

d. As investor increases the number of investments the risk reduces due to diversification. However, this diversification in the risk depends upon the type of investments added to the portfolio.

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