In: Finance
You manage a $100 million portfolio has a beta of 0.92 and an expected return of 9.8% per year. You intend to invest an additional $40 million in the portfolio so that the expected return increases to 10.8% per year. If the market risk premium is 5.0% per year, what does the beta of the new investment need to be?
Step-1:Calculation of risk free rate | |||||||||||||||||
As per Capital asset pricing model, | |||||||||||||||||
Expected return | = | Risk free rate + Beta *Market risk premium | |||||||||||||||
0.098 | = | Risk free rate + 0.92*0.05 | |||||||||||||||
0.098 | = | Risk free rate + 0.046 | |||||||||||||||
Risk free rate | = | 0.052 | |||||||||||||||
So, risk free rate is | 5.20% | ||||||||||||||||
Step-2:Calculation of expected return of new investment | |||||||||||||||||
Increased return | = | (Return of existing investment*weight of existing investment)+(Return of additional investment*Weight of additional investment) | |||||||||||||||
0.108 | = | (0.098*0.7143)+(return of addiitonal investment*0.2857) | |||||||||||||||
0.108 | = | 0.07 + return of addiitonal investment*0.2857 | |||||||||||||||
Return of addiitonal investment*0.2857 | = | 0.038 | |||||||||||||||
Return of addiitonal investment | = | 0.133007 | |||||||||||||||
So, return of new investment is | 13.30% | ||||||||||||||||
Working: | |||||||||||||||||
Existing investment | $ 100 | Million | |||||||||||||||
Additional investment | $ 40 | Million | |||||||||||||||
Total investment | $ 140 | Million | |||||||||||||||
Weight of: | |||||||||||||||||
Existing investment | $ 100 | / | $ 140 | = | 0.7143 | ||||||||||||
Additional investment | $ 40 | / | $ 140 | = | 0.2857 | ||||||||||||
Total | 1.0000 | ||||||||||||||||
Step-3:Calculation of beta of additional investment | |||||||||||||||||
As per Capital asset pricing model, | |||||||||||||||||
Expected return | = | Risk free rate + Beta *Market risk premium | |||||||||||||||
0.1330 | = | 0.052+beta*0.05 | |||||||||||||||
0.0810 | = | beta*0.05 | |||||||||||||||
beta | = | 1.62 | |||||||||||||||
Thus, | |||||||||||||||||
Beta of new investment need to be | 1.62 | ||||||||||||||||