Orb Trust (Orb) has historically leaned toward a passive management style of its portfolios. The only model that Orb’s senior management has promoted in the past is the capital asset pricing model (CAPM). Now Orb’s management has asked one of its analysts, Kevin McCracken, CFA, to investigate the use of the arbitrage pricing theory (APT) model.McCracken believes that a two-factor APT model is adequate, where the factors are the sensitivity to changes in real GDP and changes in inflation. McCracken has concluded that the factor risk premium for real GDP is 8% while the factor risk premium for inflation is 2%. He estimates for Orb’s High Growth Fund that the sensitivities to these two factors are 1.25 and 1.5, respectively. Using his APT results, he computes the equilibrium expected return of the fund. For comparison purposes, he then uses fundamental analysis to compute the actually expected return of Orb’s High Growth Fund. McCracken finds that the two estimates of the Orb High Growth Fund’s expected return are equal.McCracken asks a fellow analyst, Sue Kwon, to provide an estimate of the expected return of Orb’s Large Cap Fund based on fundamental analysis. Kwon, who manages the fund, says that the expected return is 8.5% above the risk-free rate. McCracken then applies the APT model to the Large Cap Fund. He finds that the sensitivities to real GDP and inflation are .75 and 1.25, respectively.McCracken’s manager at Orb, Jay Stiles, asks McCracken to construct a portfolio that has a unit sensitivity to real GDP growth but is not affected by inflation. McCracken is confident in his APT estimates for the High Growth Fund and the Large Cap Fund. He then computes the sensitivities for a third fund, Orb’s Utility Fund, which has sensitivities equal to 1.0 and 2.0, respectively. McCracken will use his APT results for these three funds to accomplish the task of creating a portfolio with a unit exposure to real GDP and no exposure to inflation. He calls the fund the “GDP Fund.” Stiles says such a GDP Fund would be good for clients who are retirees who live off the steady income of their investments. McCracken does not agree with Stiles, but says that the fund would be a good choice if upcoming supply side macroeconomic policies of the government are successful. With respect to the comments of Stiles and McCracken concerning for whom the GDP Fund would be appropriate:a. McCracken is correct and Stiles is wrong.b. Both are correct.c. Stiles is correct and McCracken is wrong.
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
Orb Trust (Orb) has historically leaned toward a passive management style of its portfolios.
The only model that Orb’s senior management has promoted in the past is the
McCracken believes that a two-factor APT model is adequate, where the factors are the sensitivity to changes in real GDP and changes in inflation. McCracken has concluded that
the factor risk premium for real GDP is 8% while the factor risk premium for inflation is 2%.
He estimates for Orb’s High Growth Fund that the sensitivities to these two factors are 1.25 and 1.5, respectively. Using his APT results, he computes the equilibrium expected return of the fund. For comparison purposes, he then uses fundamental analysis to compute the actually expected
return of Orb’s High Growth Fund. McCracken finds that the two estimates of the Orb High Growth Fund’s expected return are equal.
McCracken asks a fellow analyst, Sue Kwon, to provide an estimate of the expected return of Orb’s Large Cap Fund based on fundamental analysis. Kwon, who manages the fund, says that the expected return is 8.5% above the risk-free rate. McCracken then applies the APT model to the Large Cap Fund. He finds that the sensitivities to real GDP and inflation are .75 and 1.25, respectively.
McCracken’s manager at Orb, Jay Stiles, asks McCracken to construct a portfolio that has a unit sensitivity to real GDP growth but is not affected by inflation. McCracken is confident in
his APT estimates for the High Growth Fund and the Large Cap Fund. He then computes the sensitivities for a third fund, Orb’s Utility Fund, which has sensitivities equal to 1.0 and 2.0,
respectively. McCracken will use his APT results for these three funds to accomplish the task of creating a portfolio with a unit exposure to real GDP and no exposure to inflation. He calls the fund the “GDP Fund.” Stiles says such a GDP Fund would be good for clients who are retirees who live off the steady income of their investments. McCracken does not agree with Stiles, but says that the fund would be a good choice if upcoming supply side
With respect to the comments of Stiles and McCracken concerning for whom the GDP Fund would be appropriate:
a. McCracken is correct and Stiles is wrong.
b. Both are correct.
c. Stiles is correct and McCracken is wrong.
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