Risk and decision making Flashcards
What are the 2 advantages of using the CAPM as the means of establishing the discount factors used in appraising investments.
- Clearly based on the idea that discount factors should be related to project risk via the use of an appropriate beta.
- Recognises that the relevant risk of an individual investment is its systematic risk and it is on this basis that investments should be judged.
What are the 7 disadvantages of using the CAPM as the means of establishing the discount factors used in appraising investments.
- CALCULATED USING HISTORICAL VALUES: In practice, the average return on the market is usually calculated using historic rather than expected future returns, so the CAPM does not take into account potential future uncertainty, recessions or booms.
- PERFECT CAPITAL MARKET: CAPM is a methodology predicated on the notion of a perfect capital market.
- DIVERSIFIED PORTFOLIOS: There is a key assumption underlying the CAPM methodology that the firm’s shareholders have diversified market portfolios. This may not be the case if a company is unlisted, which renders the CAPM inappropriate.
- COMPARING WITH LISTED COMPANIES: Estimating the beta factor for new ventures may be problematic. Comparison with the beta of a listed company involved in a similar business may be a possible solution, but that presupposes the listed company is only in that one particular line of business, which may well not be likely. Also, the listed company with which the comparison is made may be financially geared to a different extent.
- OTHER STAKEHOLDERS: Stakeholders other than shareholders, such as directors and employees, are exposed to both the systematic and specific risk of the business. They cannot diversify away their jobs, so it would, in practice, be difficult to persuade them that they can ignore the specific risk of the business, which the CAPM methodology suggests shareholders can.
- SIMPLISTIC: The beta is calculated using statistical analysis of the difference between the market return and the return of a particular share or industry. This is a simplistic way of estimating risk as risk premiums are made up of multiple different factors rather than a single market factor.
- TREASURY BILLS ARE NOT RISK FREE: The risk free rate used to calculate the CAPM is the assumed rate on Treasury Bills, which are not truly risk free.
Why might it not be useful to use WACC when assessing a foreign investment? (7)
- There may be changes in future sources of finance or capital structure.
- The new project may be in a different risk class to the firm’s existing activities.
- The tax rate may alter during the course of the project.
- There may be changes in the dividend growth rate in future.
- The finance for the new investment may be project-specific.
- If a company is unlisted, the WACC is difficult to calculate because there are no market values to obtain accurate returns.
- The level of risk is likely to change over the period, while the WACC assumes it will stay the same. The current Ke is dependent on the current level of risk but this may change.
Why is it useful for managers to know the cost of equity capital for their companies. (4)
MNGR
- Minimum required rate of return: The cost of equity indicates the shareholders’ required rate of return and so acts as a minimum required rate of return for investment projects.
- Knowledge of the cost of equity enables managers to determine which prospective projects should be accepted and which should be rejected based on the shareholders’ minimum required rate of return. This will stimulate demand and increase shareholder value.
- Managers can use knowledge of the cost of equity in their financing decisions.
Explain how, both in theory and in practice, future loan stock issues will impact WACC.
Modigliani and Miller (with taxes):
- The larger loan stock issue should lower the firm’s WACC and increase shareholder wealth as the value of the additional tax relief is transferred to the shareholders.
- This theory suggests that the pressure of cheap debt is stronger so causes WACC to fall and therefore the optimum level of gearing is 100% as gearing up reduces WACC
In practice:
- Debt is cheaper than equity, so the overall WACC would decrease.
- Financial risk may increase as the existence of greater fixed return commitments would have the effect of making returns to shareholders more variable without any alteration in business risk.
- Taken to high levels the risk of bankruptcy could adversely affect share prices and actually
lower shareholder value, ultimately to a greater extent than the tax relief would increase it (as
also evidenced in traditional theory).
- At high levels of gearing, bankruptcy costs, tax exhaustion and agency costs can all cause the cost of debt to increase and the WACC will start to rise and the value of the company fall.
Which 4 issues affect the attractiveness of debt finance?
Agency costs and covenants:
- Separation of ownership from management of a firm can lead to suboptimal decisions being made.
- Agency costs are borne by shareholders.
- Management may often make investments that do not increase shareholder wealth and dividends worsen as a result.
- Dividend commitments can reduce agency costs.
- A high dividend payout and low retentions leads to greater scrutiny of the firm’s investment decisions by outsiders.
Tax exhaustion
Perfect market assumptions
- Risk-free debt
Direct and indirect costs of bankruptcy.
What is the reasoning underpinning the CAPM? (6)
- The CAPM is a method of calculating the cost of capital of an organisation and is based on the premise that investors require a premium for systematic risk (SR).
- The model assumes there is a linear relationship between the return of individual companies and the average return of all securities in the market.
- It also assumes that individual securities will be more or less risky than the market average in a fairly predictable/measurable way over time.
- Furthermore, the measure of this relationship can be developed into a beta factor – (ß) – for individual securities.
- ß is a measure of a share’s volatility in terms of market risk.
- CAPM states that unsystematic risk (UR) can be eliminated by diversification. Therefore the
average portfolio return depends on changes in the average market return, and the ß of shares in the portfolio
What is the risk associated with investing in a new company?
There is not much historical data and so there is no track record of profit.
What are the 6 risks associated with investing in technology companies?
- Technology companies are often loss-
making. - The value of companies in this industry is prone to fluctuation
- These companies are characterised by periodic swings in stock market sentiment that may result in over-valuation and market acceptance of products is
unpredictable. - There is a considerable level of subjectivity required to value digital assets and associated income streams, which makes their value difficult to pinpoint.
- An approach based on earnings or future cash flows is the best way to value technology cash flows but they require many estimates and technology companies are fast-evolving.
- The discount rate used to calculate the present value of future cash flows would need to build in a risk premium.
Define: Predictive analytics
- Uses historical and current data to create predictions about the future
- Increasing use of Big Data within organisations has created new forms of data that can be used to create predictions and opportunities for identifying new types of trends to understand how the organisation may be affected by future events.
3 examples of predictive analytics
- Linear regression
- Simulation
- Decision trees
What is linear regression?
- A statistical technique that attempts to identify the factors that are associated with a change in the value of a key variable such as sales or NPV.
- The dependent variable is the variable that a business is trying to predict.
- Independent variables are the factors that impact the dependent variable.
- Linear regression quantifies the relationship between the dependent variable and independent variables.
6 limitations of linear regression
LINEAR
L - Less meaningful if the data collected is inaccurate or if the error term is large.
I - basic linear regression models can only consider the Impact of one variable at a time.
N - regression equations are Not always 100% reliable.
E - unlikely to fully explain the relationship between variables, which results in an Error variable.
A- there will not Always be a linear relationship between variables and outcomes.
R - linear models may identify spurious Relationships between variables and outcomes as they do not consider the difference between correlation and causation.
Why is regression analysis useful in investment appraisal?
- Identifies factors that have strong links to the returns from a project.
- Builds an understanding of a project’s NPV to changes in these factors.
What is multiple regression analysis?
- Involves exploring whether identifying more than one independent variable reduces the error term.
- Identifies the most important independent variables that reduce the error term as low as possible.
- Aims to provide a stronger regression line that quantifies the key independent variables that are associated with changes in the value of the dependent variable.
- Can be used to help make predictions of the value of a company.
3 advantages of linear regression
SEE
S - Simple to use.
E - Easy to explain to non-financial managers.
E - can be used to predict the impact of Expanding variables beyond current estimates.
What are decision trees?
- A predictive analytics technique that can be used to identify the impact of different decisions and variables on the outcome of an investment.
- Probabilities and expected values could be used to evaluate the decision tree.
3 advantages of decision trees
- Simple decision trees are easy to explain and logical to use.
- Can be used to consider the different outcomes that can occur based on changes in a number of variables.
- Can be used to consider multiple decisions.
2 limitations of decision trees
- Variables usually need to be restricted to a small number of possible outcomes to avoid overcomplicating the decision tree.
- Large decision trees can become difficult to interpret, which restricts their overall value to the user.
What is simulation?
A technique that allows the effect of more than one variable changing at the same time to be assessed.
