Advanced financial management revision question and answer

Advanced Financial Management Block Revision Mock Exams

Maltec plc is a company that has diversified into five different industries in five different countries. The investments are each approximately equal in value. The company‟s objective is to reduce risk through diversification, and it believes that the return on any investment is not correlated with the return on any other investment. The estimated risk and return (in present value terms) of the five investments are shown below:

Required:
(a) Estimate the risk and return of the portfolio of five investments, and briefly explain the significance of your results. (

(b) Discuss the validity to investors of Maltec‟s objective of risk reduction through international
diversification.
ANSWER
(a) Portfolio return is the weighted average of the returns of the five investments. As the investments


Portfolio diversification offers no enhancements to return, although it does offer the opportunity for improved combinations of risk and return.

As there is believed to be no correlation between any of the investments, portfolio risk may be estimated by:


With a portfolio of only five investments, the benefits of diversification have reduced portfolio risk, measured the standard deviation of expected returns, to approximately that of the lowest risk individual investment. This portfolio risk reduction is quite large because of the lack of correlation between the investments. The further away the correlation coefficient is from +1, the greater the risk reduction through diversification.

(b) In theory, a well diversified investor will not place any extra value on companies that diversify. On the contrary, as diversification is expensive, and might move companies away from their core competence, a diversified company might have a relatively low market value.

However, not all investors are well diversified, and even well diversified investors might benefit from a diversified company. A diversified company might have a less volatile cash flow pattern, be less likely to default on interest payments, have a higher credit rating and therefore lower cost of capital, leading to higher potential NPVs from investments and a higher market value.

If the diversification is international the benefits of diversification will depend upon whether the countries where the investments take place are part of any integrated international market, or are largely segmented government restrictions (e.g exchange controls, tariffs, quotas).

If markets are segmented international diversification might offer the opportunity to reduce both systematic and unsystematic risk. An integrated market would only offer the opportunity to reduce unsystematic risk. Most markets are neither fully integrated nor segmented meaning that international diversification will lead to some reduction in systematic risk, which would be valued investors. It is to be hoped that risk reduction is not the only objective of Maltec; returns and shareholder utility are also important

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