Question

Suppose that a firm is considering a project in the US and one in China. The firm currently earns a 10% rate of return with a standard deviation of 0.12. The new project in the US will earn 12% with a standard deviation of 0.10 and correlation of 0.75. The new project in China will earn 15% with a standard deviation of 0.14 and correlation of 0.15. The new project will represent 20% of the firm's value. What is the expected rate of return for the entire firm if the firm invests in the US project? Write the answer in decimal form (0.10, not 10%).

The firm should invest in the China project in order to minimize risk and maximize return.

True

False

Answer 1

If firm invests in US project,

Expected return = 0.80(0.10) + 0.20(0.12)

Expected return = 10.40%

True

If firm invests in China Project risk is minimized and return is maximized

Explanation:

Standard Deviation =(w₁²s₁² + w₂²s₂² + 2w₁w₂Cov(1,2))^1/2

Standard deviation when invested in US Project = 11.18%

Standard deviation when invested in China Project = 10.40%

Expected Return of China Project = 11%

As portfolio standard deviation of China project is low and expected return is higher so risk is minimized and return is maximized