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Capital Budgeting and Portfolio Beta

See the attached file.

e. Suppose you are managing a stock portfolio consisting a mixture of high and low beta
stocks. You have information which leads you to believe that the stock market is likely to
be very strong in the immediate future, i.e., you are confident that the market is about to
rise sharply. If you want to take advantage of the situation to maximize the value of your
portfolio, what would you do now? Explain your answer.

a) Project X has an internal rate of return of 20 percent. Project Y has an internal rate of return of 15 percent. Both projects have a positive net present value. Does this mean Project X has a shorter payback than Project Y? Explain your answer.

i) In capital budgeting, why is the focus on cash flows rather than net income? Should interest payments be considered in capital budgeting? How about the changes in net operating working capital? Provide the arguments to support your answers.

1- What would be the effect if a company increases its debt ratio, but leaves its operating
income (EBIT) and total assets unchanged?

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The explanations and two examples are included in the attached file.

e. Suppose you are managing a stock portfolio consisting a mixture of high and low beta
stocks. You have information which leads you to believe that the stock market is likely to
be very strong in the immediate future, i.e., you are confident that the market is about to
rise sharply. If you want to take advantage of the situation to maximize the value of your
portfolio, what would you do now? Explain your answer.
Let us assume that stock A is low beta stocks (beta of 0.6) and stock B is high beta stocks (beta of 1.4). The portfolio in scenario 1 consists of 50% of each type of stocks.
Scenario 1: Portfolio beta on a two-asset portfolio bP = w1*b1 + w2*b2 = 1 (that is, equal to market beta)
Scenario 2: Portfolio beta on a two-asset portfolio bP = w1*b1 + w2*b2 = 1.4 (that is, equal to market beta)
Scenario 1
Weight Beta w*b
Stock A 50% 0.6 0.3
Stock B 50% 1.4 0.7
Portfolio beta 1.0

Scenario 2
Weight Beta w*b
Stock A 0% 0.6 0
Stock B 100% 1.4 1.4
Portfolio beta 1.4

The portfolio in scenario 2 consists of only type B stocks, with a higher beta. Note that the portfolio beta increases ...

Solution Summary

This solution includes explanations in capital budgeting. First, the beta of a two-asset portfolio is computed and a possible reallocation is suggested based on change in market conditions. Second, the internal rate of return (IRR) is discussed with its relationship to the net present value (NPV) and the payback period. Third, the relationship of NPV and its relationship with net income, interest payments, and net operating working capital (NOWC) are being discussed concisely. Finally, the effect of changes in debt ratio are discussed. The solution includes two clarifying examples.

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