Question

A US based MNC plans to invest in a new project EITHER in US or in Mexico. The new project is expected to take up a quarter of the firm’s total investment fund. The balance of the corporation’s investment is exclusively in an existing US project. The features of the proposed new project are as follows:

                                                          Existing US project   US project (new)   Mexico project (new)

Expected rate of return E(R)                10%                              15%                          15%

Standard deviation of E(R)                0.10                                  0.11                          0.12

Correlation of returns from new

project with returns on existing

UK project                                                 -                                     0.95                        - 0.05

Based on considerations of risk and return, determine the portfolio the MNC should choose if the goal is to generate more stable returns.

Answer 1

The MC should invest in new project in the US because of the following reasons:

1. The standard deviation of the new US project is 0.11 whereas that of Mexico is 0.12. So Mexico has slightly higher risk than from the US.

2. The returns in both projects (US and Mexico) are 15% whereas the risk is lower in US. So, the new project in the US will yield a stable return with lower risk due to lower standard deviation

3. The Correlation between the existing US project and that of the new project is very high 0.95 which is closer to one. So, it’s better off in selecting the US over Mexico (which has a low correlation of 0.05). High positive correlation in the US means firm is better off in the US.