5. Mr. Brown, who is risk-averse and prefers to have a higher return for a given...

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5. Mr. Brown, who is risk-averse and prefers to have a higher return for a given level of risk, currently invests $ 1 million on financial market. His portfolio includes three assets: Stock Google, Stock Dell and the risk-free government bond. Mr. Brown aims to maximize the expected return of his portfolio but the volatility (of return) of portfolio cannot be beyond 8%. The market values of Google's debt and equity are $20 billion and $ 80 billion respectively, while Dell's debt and equity market values are $ 30 billion and $ 60 billion. The debt of both companies is risk-free. Investors currently require 15% expected return on the Google stock and 10% expected return on Dell stock. The stock price of Goole is $300 per share. The volatilities of stock retum of Google and Dell are 20% and 10% respectively. The correlation between two returns is 0.5. The risk-free rate of return is 5%. There exist no taxes or other market frictions. Suppose Goole decides to issue an additional $30 billion of debt and uses the money to retire (repurchase) stock. Similarly, Dell issues an additional $10 billion of debt and uses the proceeds to retire its shares. Assume that the changes in capital structure do not affect the risk of debt. Considering two companies are changing capital structure, Mr. Brown may have to adjust his portfolio weights (but he doesn't change the amount of investment and he only invests on the original three assets.) Draw the CMLS before and after the capital structure change. How should Mr. Brown adjust his portfolio? (hint: the correlation between two stock returns should be the same after the capital structure change, i.e., corr(x,y)=corr(ax+b,cy+d)). 5. Mr. Brown, who is risk-averse and prefers to have a higher return for a given level of risk, currently invests $ 1 million on financial market. His portfolio includes three assets: Stock Google, Stock Dell and the risk-free government bond. Mr. Brown aims to maximize the expected return of his portfolio but the volatility (of return) of portfolio cannot be beyond 8%. The market values of Google's debt and equity are $20 billion and $ 80 billion respectively, while Dell's debt and equity market values are $ 30 billion and $ 60 billion. The debt of both companies is risk-free. Investors currently require 15% expected return on the Google stock and 10% expected return on Dell stock. The stock price of Goole is $300 per share. The volatilities of stock retum of Google and Dell are 20% and 10% respectively. The correlation between two returns is 0.5. The risk-free rate of return is 5%. There exist no taxes or other market frictions. Suppose Goole decides to issue an additional $30 billion of debt and uses the money to retire (repurchase) stock. Similarly, Dell issues an additional $10 billion of debt and uses the proceeds to retire its shares. Assume that the changes in capital structure do not affect the risk of debt. Considering two companies are changing capital structure, Mr. Brown may have to adjust his portfolio weights (but he doesn't change the amount of investment and he only invests on the original three assets.) Draw the CMLS before and after the capital structure change. How should Mr. Brown adjust his portfolio? (hint: the correlation between two stock returns should be the same after the capital structure change, i.e., corr(x,y)=corr(ax+b,cy+d)).

Answer rating: 100% (QA)

Capital Structure Change and Portfolio Adjustment for Mr Brown Current Scenario Capital Structure Google80 equity20 debt Dell6667 equity3333 debt Expe... View the full answer