Robson plc is a listed company which has generated long run annual returns of 12% with a standard deviation of 15%. It is considering launching a takeover bid for one of two unlisted UK companies.

One target is an existing customer which has generated long run annual returns of 17% with a standard deviation of 20%. The other is an existing supplier which has generated long run annual returns of 15% with a standard deviation of 8%. Both target companies are the same size and would account for 20% of the enlarged group if acquired.

The correlation coefficient between the returns of Warnock plc and those of the customer and the supplier have been estimated as +0.3 and -0.2 respectively.

Required:

1. Calculate the expected risk and return of the enlarged group should the company acquire the customer or the supplier.

(6 marks)

2. Advise the company on whether it should acquire either target company and, if so, which target company would be preferred.

(8 marks)

3. Clearly explain the limitations of using portfolio theory when making decisions of this nature.

(6 marks)

(Total 20 marks)