QUESTION 2 28 MARKS

Bean Ltd is a division of Earl Enterprises and has been allocated R5 million for capital expansion in the forth-coming year. The management of Bean Ltd believes that the company must spread its risk by investing in projects with different risk profiles and has identified two possible investments.

Marine Shark The Fisheries Bait market

Favourable

Neutral

Unfavourable

Book value in million

Market value in million

Standard deviation of returns

Covariance with the market

The risk-free rate is 5% and there is no company or personal taxation.

16% 20% 14% 10% 12% 8% 2% 0% 6% 12m R8m R8m R12m 5,4% 7,8% 3,2% 0,0024 0,0023

Required:

The capital available to Bean Ltd is sufficient to invest in only one of the projects. The following information has been made available:

Estimated return %

Economic growth (annual average)

Probability of occurrence

Project 1

Project 2

Existing investments

Zero

0,3

14

8

6

3%

0,4

10

16

12

6%

0,3

8

22

16

Book value

R5m

R5m

R10m

Market value

R5m

R5m

R15m

178

The division manager has requested the accountant to determine which of the two projects should be accepted using the portfolio theory to make the selection.

Required:

1. Usingtheaboveinformation,calculatewhichinvestmentBeanLtdshouldselectin line with the portfolio theory (expected value and standard deviation). (20 Marks)

2. Identify and describe the kind of risk the management of Bean Ltd wishes to spread by investing in different investments and state whether they should be concerned about reducing such risk.