Alabama Case Corporate Finance

Q.1

A bank with an outstanding borrowing of $70m at 0.75% above LIBOR has the alternative of rolling over the existing loan at the same rate or increasing it to $110m at 0.85% above LIBOR. The funds are currently committed to credit lines yielding 1.2% above LIBOR, but the bank reckons that if it reduces its spread to existing customers to 1.1% it could place the extra funds. Should it?

Q.2 

Simon is considering investing in stocks and shares that have offered average annual return of 9% and standard deviation of 18% and bonds which have offered average annual returns of 4% and standard deviation of 10% in the recent past.

(a) If the correlation between stocks and bonds is 0.35, what is the expected return of a portfolio with 50% invested in each type of security and what is the risk of this portfolio?

(b) Simon is a cautious man and wishes to reduce risk further. You have advised him to add a money market (MM) fund to the portfolio and reduce amounts in the stocks and shares and bonds, so that one third by value is held in each type of asset. The characteristics of the money market fund are expected return of 2.0% and standard deviation of 5%. What are the expected return and risk of the new portfolio?

Correlations: MM fund and stocks 0.18, MM fund and bonds 0.34

(c) You have just thought about another possibility for his portfolio. Simon does not mind taking excess risk provided he can earn an expected return of 9% from the portfolio. The returns on 90-day T-bills are around 2.0% per annum. Assuming that Simon can borrow and lend at the risk free rate of return, advise how much Simon should invest in the portfolio (comprising of just stocks and shares and bonds, 50%, 50%) and the risk free asset so that the combination of the risky portfolio and risk free asset provides 9% expected return. What proportion would be invested in bonds, stocks and the risk free asset and what would be the risk of the new portfolio?

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