ACC00716 Finance Assignment: Modern Portfolio Theory and Analysis

This finance assignment, focusing on ACC00716, delves into portfolio analysis and Modern Portfolio Theory (MPT). The report begins with the computation of expected returns for Cochlear and a hypothetical company using the Capital Asset Pricing Model (CAPM). It then explores portfolio characteristics, emphasizing the importance of MPT in evaluating investments by considering both risk and return. The assignment differentiates between unsystematic and systematic risks, highlighting diversification as a strategy to mitigate unsystematic risk. The systematic risk, measured by beta, is analyzed for Cochlear and another hypothetical company, reflecting the application of MPT principles. The analysis extends to portfolio formation, demonstrating how diversification reduces unsystematic risk and the impact of negative correlation. The report concludes by comparing the performance of individual stocks versus a portfolio, emphasizing the importance of risk-adjusted returns for investment decisions. The assignment uses references from Brealey and Myers, Damodaran, Petty et. al., and Watson and Head to support the analysis and findings.

FINANCE
ACC00716
STUDENT ID:
[Pick the date]

Question 2
PART A
(i) The computation of the expected returns on selected company (i.e. Cochlear) is carried
out based on CAPM and shown below.
(ii) The computation of the expected returns on hypothetical company is carried out based on
CAPM and shown below.
PART B
The computation of the portfolio characteristics is shown as follows.
Question 3
Modern Portfolio Theory (MPT)

With regards to evaluation of investments, two key parameters are pivotal namely risk and
returns. In this regards, contribution of MPT is vital as it highlights that investors must not
use any of these two measures alone for making portfolio allocation decisions. This makes
sense considering the basic assumption that investors are risk averse and behave rationally.
As a result, when presented with investment choices offering same returns, the investor
would choose one where risk is lowered. The implication of this is that investors would invest
in risky investments only when the returns that can be potentially derived on these are large
enough to act as a material reward for assumption of risk. As per MPT, the objective which
drives every investor is to maximise risk adjusted returns (Brealey and Myers, 2017).
In relation to risk management, it is noteworthy that the following two risks are associated
with investing in stocks as highlighted below.
1) Unsystematic risk – This risk is related to individual stocks investment as the price of an
individual stock is driven by a host of factors which present a potential risk source. In
order to lower this risk, MPT highlights that a diversified portfolio ought to be created
which has representation from various sectors. In this manner unsystematic risk is
lowered since the movement of stocks tend to hedge against each other. The effectiveness
of diversification as a risk reduction strategy is dependent on the extent of negative
correlation between the constituent assets or stocks (Damodaran, 2015).
2) Systematic risk – This refers to the general risk that is pervasive in the stock market and
every participant is exposed to this risk. This risk cannot be reduced by diversification.
The measurement of this risk is beta. Beta for any stock is computed by taking the
relative movement of stock prices in comparison to the benchmark index over a period of
time (Watson and Head, 2015).
Individual Stock Analysis
The allocated company is Cochlear Limited whose systematic risk is 0.5. This is expected
considering that the company is a global leader in providing hearing aids. As per some
estimates, 60% of the global hearing aid market is served by Cochlear. Considering the
dominant position of the company in the market, the risk associated would be low which
would result in lesser fluctuations in stock price. The other company has a negative beta
value. This would represent that the stock of hypothetical company tends to have a general
movement opposite to the benchmark index (Petty et. al., 2016). The expected returns for the
two individual companies stock clearly highlight the MPT in play as higher risk associated

with COH is leading to investors demanding a higher return than the hypothetical company
stock.
Portfolio Analysis
In accordance with MPT, a key advantage of portfolio formation is that the unsystematic risk
is reduced. In the wake of the relevant theory, the portfolio formed in this case would be
expected to have superior performance as compared to the two constituent stocks. This is
further validated by the negative correlation that exists between the two companies stock
movements.
The above portfolio characteristic computation does reflect at lower beta value but the returns
are also adjusted downwards when compared to the COH stock. A better mechanism to
compare the performance of the three investment choices would be to calculate the risk
adjusted returns in each case (Brealey and Myers, 2017).
The risk adjusted returns for the portfolio is higher than the two individual stocks and hence
the investors as per MPT should invest in the portfolio (Damodaran, 2015).

References
Brealey, R., and Myers, S., (2017) Principles of Corporate Finance. 9th ed. New York City:
McGraw –Hill, pp. 189-190
Damodaran, A. (2015). Appl0ied corporate finance: A user’s manual 3rd ed. New York:
Wiley, John & Sons, pp. 178
Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M., and Nguyen, H. (2016)
Financial Management, Principles and Applications. 6th ed. NSW: Pearson Education, French
Forest Australia, pp. 142
Watson. D., and Head, A., (2015) Corporate Finance – Principles and Practice.6th ed.
London: Pearson, pp. 123-124