- 20 Marks
Question
Sunmola Funds (SF) Plc. has a portfolio of short-term investments in the shares of four quoted companies.
| Company | Holding |
|---|---|
| Tomiwa (T) | 100,000 shares |
| Pascal (P) | 155,000 shares |
| Binta (B) | 260,000 shares |
| Yetunde (Y) | 420,000 shares |
You have the following additional information:
| Company | Beta | Market Value Per Share (Kobo) | Expected Total Return on Investment p.a (%) |
|---|---|---|---|
| T | 1.55 | 280 | 21.0 |
| P | 0.65 | 340 | 12.5 |
| B | 1.26 | 150 | 18.0 |
| Y | 1.14 | 9.5 | 18.5 |
The market risk premium is 10% per year, and the risk-free rate is 6% per year.
Required:
a. Estimate the Beta of SF Plc.’s short-term investment portfolio. (4 Marks)
b. Recommend, giving your reasons, whether the composition of SF Plc.’s short-term investment portfolio should be changed using relevant calculations. (10 Marks)
Hint: Consider the alpha values of the shares and the propriety of investing short-term funds in equity.
c. Explain THREE factors that a financial manager should take into account when investing in marketable securities. (6 Marks)
Answer
a. Portfolio Beta Calculation:
The risk of SF Plc.’s short-term investment portfolio may be measured by the weighted average beta of the four shares. The weighting is by the market value of the shares.
b. Portfolio Composition Recommendation:
The composition of the short-term investment can be evaluated through two questions:
- Is the performance of individual investments within the portfolio satisfactory?
- Is the portfolio composition suitable for short-term investments?
(i) CAPM Analysis for Required Return:
Using CAPM, the required returns for each share are calculated as follows:
Alpha Values and Recommendations:
| Company | Expected Return (%) | Required Return (%) | Alpha (%) | Recommendation |
|---|---|---|---|---|
| T | 21.0 | 21.5 | -0.5 | Over-valued, Sell |
| P | 12.5 | 12.5 | 0 | Properly valued, Hold |
| B | 18.0 | 18.6 | -0.6 | Over-valued, Sell |
| Y | 18.5 | 17.4 | 1.1 | Under-valued, Buy more |
Conclusion:
- Shares in companies T and B are not expected to yield satisfactory returns relative to their risk and should be sold.
- Hold shares in P and consider buying more in Y.
(ii) Suitability for Short-Term Investment:
- Short-term investments are generally for liquidity purposes, with minimal tolerance for price volatility.
- SF Plc.’s equity investments are exposed to price fluctuations and company risks, which may be inappropriate for short-term needs.
- For lower risk, it is recommended to focus on fixed-interest marketable securities like Treasury Bills, Certificates of Deposit, and Bills of Exchange.
c. Factors to Consider for Marketable Securities:
- Default Risk: The possibility that interest and/or principal may not be paid as scheduled, especially for fixed-interest investments.
- Price Risk: The risk of value fluctuations, often due to interest rate changes, which is typically minimized in short-term investments.
- Marketability: The ease of converting securities to cash at a price close to the market value without delay.
- Taxation: Consider any special tax effects on chosen securities.
- Yield: Aim for maximum yield within acceptable risk and liquidity limits.
- Foreign Exchange Risk: If securities are denominated in foreign currency, consider exchange rate risk.
- Investment Amount: Some investments have minimum size requirements.
- Investment Period: Match the type of security with the timing of future cash needs.
- Topic: Portfolio Management
- Series: MAY 2018
- Uploader: Dotse