A division of Bewcast plc has been allocated a fixed capital sum the main board of directors for its capital investment during the next year. The division‟s management has identified three capital investment projects, each potentially successful, each of similar size, but has only been allocated enough funds to undertake two projects. Projects are not divisible and cannot be postponed until a later date.
The division‟s management proposes to use portfolio theory to determine which two projects should be undertaken, based upon an analysis of the projects‟ risk and return. The success of the projects will depend upon the growth rate of the economy. Estimates of project returns at different levels of economic growth are shown below:
(b) What are the weaknesses of the evaluation technique used in (a) above, and what further information
might be useful in the evaluation of these projects?
(c) Suggest why portfolio theory is not widely used in practice as a capital investment evaluation technique.
(d) Recommend, and briefly describe, an alternative investment evaluation technique that might be applied the division.
(a) (Tutorial note: as there are only three projects to be considered (and only two of these can be adopted) the simplest solution is to calculate the standard deviations and mean returns of the two asset portfolios directly.)
No portfolio is absolutely dominant in mean variance efficiency terms ie, higher return is always accompanied
higher risk. Much will depend upon the investors‟ utility functions for risk but portfolio (2 and
3) seems to offer a fair return for a very low risk.
Tutorial note: an alternative approach using covariance’s is given below:
Calculation of expected return and risk.
(i) It only considers the diversification effects of a two asset portfolio. The impact of the new projects on all Beweast‟s existing projects would be much more important.
(ii) Accurate data on returns and probabilities is required. Other information:
(i) Are the projects of different lives?
(ii) How have the returns been measured?
(iii) Can further cash be raised if all the projects can be demonstrated to have positive
(c) Reasons for the lack of use of portfolio theory
(i) If we wished to analyse the impact of the new project on all of Beweast‟s existing projects the
number of calculations would be enormous.
(ii) Accurate forecasts of returns are required.
These two problems would make the practical application of portfolio theory a time consuming and costly business.
(d) One such alternative technique is the capital asset pricing model. Given certain assumptions (including perfect capital markets and homogeneous investor expectations) the capital asset pricing model states that the required rate of return on an investment is the risk free rate plus the market risk premium weighted a premium for systematic (undeliverables) risk. Systematic risk is measured beta which relates the covariance between the expected return on the investment and expected return on the market portfolio to the variance of the market portfolio. The model may be used in the determination of an appropriate weighted average cost of capital to use as a discount rate in a capital investment, a rate which takes into account the specific systematic risk of the project concerned. The model is, however, subject to criticism with respect to its theoretical assumptions and practical application.
Other suggestions include: Simulation
Sensitivity analysis Certainty equivalents
Capital rationing techniques.