Question

Porto Berhad is an all-equity firm. The company is considering the following projects:

Project	Beta	Expected return
Barcelona	0.70	11%
Juventus	0.85	14%
PSG	1.30	16%
Chelsea	1.50	18%

The T-bill rate is 9 percent and the expected return on the market is 12 percent.

a.Evaluate which projects have higher expected return than the firm’s 12 percent cost of capital

b. Assess which projects would be incorrectly accepted or rejected if the firm’s overall cost of capital were used as a hurdle rate.

Pension funds pay lifetime annuities to recipients. If a firm expects to remain in business

indefinitely, its pension obligation will resemble a perpetuity. Suppose, therefore, that you are

managing a pension fund with obligations to make perpetual payments of RM 2 million per year

to beneficiaries. The yield to maturity on all bonds is 16%.

c. If the duration of 5 year maturity bonds with coupon rates of 12% (paid annually) is 4 years and the duration of 20 year maturity bonds with coupon rates of 6% (paid annually) is 11 years, how much of each of these coupon bonds (in market value) will you want to hold to both fully fund and immunize your obligation?

(d) What will be the par value of your holdings in the 20 year coupon bond?

Answer 1

a) Projects Juventus , PSG and Chelsea, with expected returns of 14% ,16% and 18% respectively, have higher returns than the firm’s 12% cost of capital.
b)
Project	Beta	Risk Free Rate (RF)	Expected Market Return R(m)	Expected Return= RF + Beta x (Rm - RF)		Expected return (Given)	Hurdle Rate = 12% Comparing With Expected Return	Lesser than 12% are rejected and greater than 12% are accepted.
Barcelona	0.7	9.00%	12.00%	11.10%	>	11.00%	Correctly Rejected	11.10 %< 12%
Juventus	0.85	9.00%	12.00%	11.55%	<	14.00%	Incorrectly Rejected	11.55%<12.0%
PSG	1.3	9.00%	12.00%	12.90%	<	16.00%	Correctly Accepted	12.90%>12%
Chelsea	1.5	9.00%	12.00%	13.50%	<	18.00%	Correctly Accepted	13.50%>12%
Using the firm’s overall cost of capital as a hurdle rate, accept projects PSG and Chelsea.