Finance Assignment: Risk and Return Analysis with Modern Portfolio Theory

This finance assignment focuses on the application of modern portfolio theory to analyze risk and return of financial assets. It explains the concept of diversification of risks using mathematical formulation and the importance of forming a portfolio of assets to leverage returns against identified risks.

Running head: FINANCE
Finance
Name of the Student
Name of the University
Author Note

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FINANCE ASSIGNMENT
Answer to Question 1:
Requirement a:
Particulars Amount
Debt Amount (in million) A $103.80
APR B 5%
Total Period (in years) C 3
Nos. of Compounding
Periods p.a. D 12
Total Nos. of
Compounding Periods E=CxD 36
Investment Fund (in
million) F=A/[(1+B/D)^E] $89.37
Requirement b:
Particulars Amount
Current Annual Operating
Revenue (in million) A $1,226.66
Annual Growth Rate B 5.77%
Total Period (in years) C 10
Nos. of Compounding
Periods p.a. D 1
Total Nos. of
Compounding Periods E=CxD 10
Annual Operating
Revenue after 10 years (in
millions) F=Ax[(1+B/D)^E] $2,149.56

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Requirement c:
Particulars Investment A Investment B Investment C
APR A 4.93% 5.00% 4.91%
Nos. of Compounding
Periods p.a. B 12 6 365
EAR C=[(1+A/B)^B]-1 5.04% 5.11% 5.03%
Requirement d:
Particulars Amount
New Equipment Cost A $5,74,000.00
APR B 4.50%
Total Period (in years) C 20
Nos. of Compounding
Periods p.a. D 12
Total Nos. of
Compounding Periods E=CxD 240
Monthly Installment
F=(AxB/D)/[1-
(1+B/D)^-E] $3,631.41
Requirement e:
Particulars Amount
Face Value A $1,000.00
Coupon Rate B 5.20%
Total Period (in years) C 10
Nos. of Coupon Payments
p.a. D 1
Total Nos. of Coupon
Payments E=CxD 10
Coupon Payment F=(AxB)/D 52
Current Price G $1,170.00
Yield to Maturity
G=RATE(E,F,-
G,A,0) 3.19%

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Requirement f:
Particulars Amount
Face Value A $1,000.00
Coupon Rate B 8.00%
Total Period (in years) C 7
Nos. of Coupon Payments
p.a. D 4
Total Nos. of Coupon
Payments E=CxD 28
Coupon Payment F=(AxB)/D 20
Required Return p.a. G 3.90%
Required Return per
quarter H=G/D 0.98%
Current Bond Price
I=[Fx{1-(1+H)^-
E}/H]+[A/(1+H)^
E] $1,250.10
Answer to Question 3:
The concept of interpretation of measurement of risk and return is explained with the
application of modern portfolio theory. Modern portfolio theory is one of the most prominent
theories when individual or company intends to perform the financial and investment
analysis. This particular theory helps in explanation of the diversification of risks using the
mathematical formulation. As per this theory, the objective of investors is to select portfolio
yielding maximum level of expected return given the minimum level of risk. Or they can seek
to make investment in such portfolio of assets that helps in minimizing the risk associated
with investment and generating higher return. Therefore, the theory intends to make use of
best diversification strategy relying on theoretical knowledge and diversifying the risks that is
associated with making investment in the financial assets. Investors are able to have the most
efficient portfolio selection by analyzing the various portfolio of assets that is based on
expected returns and standard deviation and variations of several other assets portfolio. The

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main assistance of theory is associated with reducing the level of risks if the investors are
thinking of making investment in the assets portfolio moving together (Way et al. 2017).
The construction of modern portfolio theory is done on several assumptions and
fundamentals. Factors determining buying of securities are associated with risks and buying
and selling of assets does not involve any transportation costs. Investors are capable of
making investment regardless of size of securities and the market is assumed to be infinite
liquid. When making investment decision, tax is not considered as an important factor under
this theory and the investors does not regard dividends and capital gain as differential factor
for making investment. Investor’s shares identical views on measurement of risks associated
with the investments being made. The reasons why buyers are interested in buying the shares
are that it is associated with risk level that will be corresponding to the returns generated.
Sellers on other hand will be interested in selling the securities possessed by them because
other securities are available in the market whose desired return corresponds to volatility
level (Kuehn et al. 2017).
Investors are required to make two crucial decisions when making investment in
portfolio of financial assets and when they are required to do the selection of best portfolio of
assets among the available other assets portfolio. Such decisions will provide investors with
the considerable risk and return opportunities. Determining a set of efficient portfolio of
financial assets is the first decision and selecting the best portfolio among the given set of
efficient portfolio is the second decision that needs to be taken (Rice 2017). Therefore, it can
be concluded that the main objective of this theory is to select the portfolio of assets by
proper risk diversification and providing investors with higher average returns.
Capital assets pricing model helps in explanation of relationship between return and
risk of financial assets portfolio. A risk free rate is introduced in this model and the use of

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riskless rate helps investors in leveraging their risk associated with the portfolio by short
selling the risk free rates and buying more shares in the market. The reason behind the
formation of the portfolio of assets is to diversify the risks associated with individual assets.
However, the formation of portfolio of assets does not lead to complete diversification of risk
due to presence of systematic risk associated with the assets. If the coefficient between the
financial assets in the portfolio is low, then it would be easy for investors to make the
diversification of the risk factors (Fernandez 2017).
There are two company that is case company and hypothetical company and the proxy
risk free rate is assumed to be 2.76%. Market risk premium is assumed to be 6.5% and beta
value of case company and that of hypothetical company stood at 1.34 and -0.25 respectively.
Expected return of case company is 11.47% and that of hypothetical company stood at
1.14%. It can be seen that return generated from case company is considerably higher than
hypothetical company. However, the risks associated with each asset can be diversified by
forming the portfolio of these two assets by making investment in equal proportion.
The value of case company beta is indicative of the fact that security is volatile
compared to market and the negative beta value indicates that fall in market will lead to rise
in security value and vice versa. When aligning the risk profiles with the portfolio value, beta
plays a crucial role. Investors prefer stocks with higher beta value when they seek investment
in volatile assets for generating higher return (Kuehn et al. 2017).
Now, when forming the assets portfolio by making equal investment in shares of both
case company and hypothetical company, they are able to diversify the risk and average their
total return. It can be seen that the expected portfolio return is computed at 6.5% and the
value of portfolio beta stood at 0.55. Therefore, it is very clear from the computed figures that
the portfolio has reduced level of volatility when compared to market as indicated by value of

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beta and the expected return is significantly higher than the returns generated by the
individual stocks. It can be concluded using theoretical knowledge that formation of portfolio
helps investors in leveraging their returns against the identified risk and increasing the
average return generated. Nevertheless, investors are able to reduce the total risks at an
acceptable level by diversifying the systematic risks, although the unsystematic risks cannot
be diversified due to external factors presence. Hence, investors are often advised to form the
portfolio by selecting the suitable assets so that they can increase their expected return and
minimize the overall risks.

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References list:
Bloomberg.com. (2018). Australian Rates & Bonds. [online] Available at:
https://www.bloomberg.com/markets/rates-bonds/government-bonds/australia
Damodaran, A., 2016. Damodaran on valuation: security analysis for investment and
corporate finance (Vol. 324). John Wiley & Sons.
Fernandez, P., 2017. CAPM: The Model and 307 Comments About It.
Finance.yahoo.com. (2018). BGA.AX : Summary for BEGA FPO - Yahoo Finance. [online]
Available at: https://finance.yahoo.com/quote/BGA.AX?p=BGA.AX [Accessed 17 Apr.
2018].
Hawley, J.P. and Lukomnik, J., 2018. The Third, System Stage of Corporate Governance:
Why Institutional Investors Need to Move Beyond Modern Portfolio Theory.
KUEHN, L.A., Simutin, M. and Wang, J.J., 2017. A labor capital asset pricing model. The
Journal of Finance, 72(5), pp.2131-2178.
Rice, B., 2017. The Upside of the Downside of Modern Portfolio Theory.
Way, R., Lafond, F., Farmer, J.D., Lillo, F. and Panchenko, V., 2017. Wright meets
Markowitz: How standard portfolio theory changes when assets are technologies following
experience curves.

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