Question

ABCO is a conglomerate that has ksh4 billion in common stock. Its capital is invested in four subsidiaries: Entertainment (ENT), Consumer products (CON), Pharmaceuticals (PHA) and insurance (INS). The four subsidiaries are expected to perform differently, depending on the economic environment
as follows:

investment in ksh millions Poor economy Average economy Good economy

ENT 1,200 20% -5% -8%
CON 800 15% 10% -20%
PHA 1,400 -10% -5% 27%
INS 600 -10% 10% 10%

Assuming that the three economic outcomes (1) have an equal likelihood of occurring and (2) that the good economy is twice as likely to take place as the other two:
i) Calculate the individual expected returns for each subsidiary
ii) Calculate the implicit portfolio weights for each subsidiary and an expected return and variance for the equity in the ABCO Conglomerate

a) Asssume in a) above that ABCO also has a pension fund, which has a net asset value of ksh 5 billlion, implying that ABCO’s stock is really worth ksh 9 billion instead of ksh 4 billlion. The sh 5 billion in pension fund is invested in short term government risk free securities yielding 5% per year. Recalculate parts i) and ii) of a) to reflect this information.

b) Assume the in a), ABCO decides to borrow sh 8 billion at 5% interest to triple its current investment in each of its four lines of business. Assume that this new investment has the same return outcomes as the old investment.
(I) Answer part i) and ii) of a) given the new investment
(II) How does this result compare with the results from a)?
(III) To whom does this return belong? Why?

c) Explain how ABCO would manage its portfolio prudently

Answer 1

Formula sheet