corporate finance BUS 286

Corporate Finance Exam Revision
Topic 5: Risk and Return

Topic 6: Portfolio Theory

Textbook Chapter 7: Risk and Return

1. The magnitude of the gain from diversification of a portfolio comprising two assets
is dependent on:

[A] the correlation coefficient between the assets
[B] the risk of the two assets
[C] the expected return of the two assets
[D] all of the above

Answer is A. The correlation coefficient describes the way in which the returns on two
assets are related. As such it also represents the potential reduction in risk (i.e.
diversification benefit) from forming a portfolio from these two assets.


2. The highest diversification benefits are obtained when assets are:

[ A ] weakly positively correlated
[ B ] zero correlated
[ C ] perfectly positively correlated
[ D ] perfectly negatively
correlated

Answer is D. The benefits of diversification increase as the correlation coefficient
decreases and when the correlation coefficient is –1, unsystematic risk can be eliminated
completely


3. From the following information, calculate the expected return and standard
deviation of a portfolio that consists of 60% of Security A (expected return of 0.10
and standard deviation of 0.03) and 40% of Security B (expected return of 0.20 and
standard deviation of 0.05), assuming the correlation between A and B is -0.8.

[A] E(R) = 0.152,  = 0.161
[B] E(R) = 0.138,  = 0.012
[C] E(R) = 0.14,  = 0.085
[D] E(R) = 0.14,  = 0.012


Answer is D.
Expected Return, E(R) = W1R1 + W2R2 = 0.14

Variance, 2
= W1212 + W 2 2 + 2  W11 W22
2
= (0.6)2(0.03)2 + (0.4)2(0.05)2 + 2(-0.8)(0.6)(0.03)(0.4)(0.05) = 0.000148 (= 1.48 x 10-4)

Standard Deviation =  0.000148= 0.0122
=
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, Corporate Finance Exam Revision

4. If two investments, A and B, have identical risk, but A has a higher return, which
investment will a risk-averse investor choose?

[A] investment A
[B] investment B
[C] indifferent between investments A and B
[D] both investments A and B

Answer is A. A risk-averse investor will select the investment with the highest return
given identical risk or the lowest risk given identical return, making investment A the
preferred investment. Therefore, A is the correct answer.


5. Which of the following statements best describes the effect on portfolio risk of an
increase in the number of securities in the portfolio?

[ A ] total risk decreases and unsystematic risk
decreases [ B ] total risk decreases and systematic risk
decreases
[ C ] total risk increases and systematic risk decreases
[ D ] total risk increases and unsystematic risk decreases

Answer is A. As the number of securities increases, the unsystematic risk decreases and
therefore the total risk decreases. The level of systematic risk, however, will remain
unchanged with the increase in assets. Therefore, A is the correct answer.

Risk



Unsystematic risk


Unsystematic risk



Systematic risk


No. of securities




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, Corporate Finance Exam Revision
Topics 8 & 9: Dividend Policy and Capital Structure

Textbook Chapter 11 : Payout Policy
Textbook Chapter 12 : Principle of Capital Structure
Textbook Chapter 13 : Capital Structure Decisions


1. The tax system in which investors are able to use tax credits on company tax paid
on dividends is known as:

[ A ] a classical tax system
[ B ] an imputation tax system
[ C ] a franked tax system
[ D ] a withholding tax system

The correct answer is B. A classical tax system effectively taxes dividends twice, once at
the company level and once at the shareholder level. The imputation tax system removes
the double taxation by giving shareholders an associated tax credit for company tax
already paid. The imputation tax system allows companies to pay dividends that carry
credits for income tax paid by the company. Such dividends are known as franked
dividends and the tax credits can be used by resident shareholders to reduce their income
tax.


2. On 31 July 2005 Cruz Ltd’s closing share price was $42.67. On 1 August 2005 the
shares will begin to trade on an ex-dividend basis. Suppose a fully franked dividend
of $1.20 per share is to be paid. If the company tax rate is 30 per cent, what is the
expected ex-dividend share price?

[ A ] $38.57
[ B ] $40.96
[ C ] $41.11
[ D ] $42.00


The dividend is fully franked and carries a tax credit Tc  1.20
D1  0.30 = $0.5143
of
Tc 0.70
Hence, if expectations of Cruz Ltd’s future cash flows remain the same, then the ex-
dividend drop-off should be equal to the dividend plus the tax credit. That is,
$1.20 + $0.5143 = $1.7143.

Or Teff = Tc(1-u) = 0.30(1-1) = 0
D (1  1.20 (1  0)  1.7143
T )
Dividend plus tax credit 1  eff
1  0.30
= Tc


Therefore, the expected ex-dividend share price should be $42.67 – $1.7143 = $40.96.

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, Corporate Finance Exam Revision
Hence, the correct answer is B.




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