Portfolio Theory with Application to Rolls Royce

Table of Contents

  Page  

  Contents  I

  List of Tables  I

  List of Figure  II

  List of Abbreviations  II

1.  Introduction  1

2.  Portfolio Theory  1

3.  Capital Asset Pricing Model  2

4.  The Company Rolls-Royce plc  3

4.1.  Rolls-Royce Business Segments  3

4.1.1.  Civil Aerospace  3

4.1.2.  Defence Aerospace  3

4.1.3.  Marine  3

4.1.4.  Energy  4

4.2.  Corporate Objectives  4

5.  The Application to Rolls-Rolls plc  4

5.1.  Financial Information  4

5.2.  Diversification  5

5.3.  Capital Asset Pricing Model  6

6.  Critique  6

7.  Conclusion  6

  References  7

  Word Count  7

  List of Tables  

Table 1:  Sales by Division (real) 1999 2002  4

Table 2:  Divisional Sales ( ) 1999 2003  5

Table 3:  Divisional Correlations of Sales  5

I

List of Figures  

Figure 1: Equivalent Offsetting Fluctuations in Return 1  

Figure 2: Available Protfolio Risk -Return Combinations 2  

Figure 3: Systematic and Unsystematic Risk 2  

Figure 4: The Capital Asset Pricing Model 3  

Figure 5: Rolls-Royce Time Line 1884 – 2000 3  

Figure 6: Rolls-Royce Business Profile 4  

Figure 7: Undelying Profit 5  

Figure 8: Margins per Division 5  

Figure 9: Sales of Civil and Marine Division 6  

Figure 10: Calculation of Cost of Capital 6  

List of Abbreviations  

CAPM Capital Asset Pricing Model  

MPT Modern Portfolio Theory  

RR Rolls Royce  

SD Standard Deviation  

SML Security Market Line  

II

“designed to even out the bumps” ⁶ (see “Modern portfolio philosophical opposite of traditional stock mix of investments is less risky than putting picking.“ ¹ It provides a tool with which it is all your money in a single stock ⁷ .

possible to reduce the risks in business and private investments. At the same time it is Assuming that a portfolio contains two risky the basis for the Capital Asset Pricing assets: one that pays off if the sun shines, Model (CAPM). another that pays off if it doesn't. A portfolio that contains both assets will This short assey introduces both the always pay - rain or shine. Thus, adding theoretical framework of Modern Portfolio one asset to another can reduce the Theory (MPT) and the CAPM which are overall risk of our all-weather portfolio. then applied to Rolls-Royce plc. As this is just an overview the reader must be aware

that this outline doesn´t go too deep.

2. Portfolio Theory

MPT – or portfolio theory – was introduced in 1952 by Harry Markowitz ² . It explores how risk averse investors construct portfolios in order to optimise expected returns for a given level of market risk . The theory

Figure 1: Equivalend Offsetting Fluctuations in Return

quantifies the benefits of diversification. Out of a universe of risky assets, an efficient frontier of optimal portfolios can be The crucial insight of MPT is that the risk of

constructed. Each portfolio on the efficient an individual asset is of little importance to

frontier offers the maximum possible the investor. What matters is its contribution

expected return for a given level of risk. ³ to the portfolio's risk as a whole. This is meant by diversification. But this is only

To most investors, diversification is intuitively obvious: "Don't sun and rain assets are perfectly

put all your eggs in one basket." negatively correlated which is not often

Diversification helps spread risk between the case in reality.

countries, currencies or markets. It makes sure that the investor is able to benefit from The weighting in a portfolio plays a crucial

opportunities from around the world. It part. A few observations can be made for

provides him with a means of hedging bets the all-wheather portfolio. They are

against crises ⁴ and unexpected events essential for the understanding of MPT ⁸ .

(stock market crashes or natural disasters). 5 The line from A to F builds the opportunity set representing the possible combinations.

For this reason international diversification The combination at point C dominates

makes very good sense. A globally over point E, since point C offers a better

diversified portfolio represents less risk than return for the same risk. The combinations

a diversified domestic portfolio If you have between D and F are less attractive than

shied away from investing abroad, you those between A and D. Therefore, the

have actually been subjecting your rationale investor chooses a portfolio in the

portfolio to greater risk.

⁶ see: Pike; Neale: Corporate Finance and Investment; page 310 ⁷ It is also interesting to note that risk falls steeply as

¹ www.moneychimp.com/articles/risk you begin to diversify. With a holding of around 40

² with his paper "Portfolio Selection" (1952)

stocks, all the benefits from diversification have been ³ www.moneychimp.com/articles/risk

almost nearly achieved.

⁴ such as war or oil shortages

⁸ Figure 2 shows the risk and return relation if the ⁵ taken from Markowitz: Portfolio Selection, page 19 ff assets are weighted differently

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