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Corporate Finance Revision > Risk and Return > Flashcards

Risk and Return Flashcards

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1
Q

What is the return?

A

The expected outcome of an investment. I.e. NPV or IRR.

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2
Q

What is the 2 elements within risk?

A
  1. EXTENT to which the actual outcome may vary from the expected outcome
  2. LIKELIHOOD (probability) of this variance occurring
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3
Q

What risk considerations attempt to do?

A
  1. Identify and understand risks
  2. Evaluate risks (extent and lliklihood)
  3. Take appropriate action through accepting neccessary risks, reducing risks or avoiding risks
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4
Q

What are the 4 risk evaluation methodologies?

A
  1. Sensitivity Analysis
  2. Probability Analysis
  3. Modern Portfolio theory
  4. Capital Asset Pricing Model.
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5
Q

What is the rationale of sensitivity analysis?

A

To ascertain the riskiness of a project to changes in its input variables (i.e. sales volumes forecasts and direct unit cost forecasts)

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6
Q

What is the outcome of sensitivity analysis?

A

The sensitivity (safety margin) of each input variable i.e. by how much it can vary before the investment decision changes from accept to reject or vice versa

The riskiest elements of the forecasts are those with the lowest absolute safety margins (i.e. nearest to zero)

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7
Q

How do you calculate sensitivity analysis for a project with simple annuity cash flows?

A
  1. Calculate the NPV of the project using forecasts of input variables and the sensitivity analysis formulae.
  2. Calculate the value of each input variable in turn which would result in a project NPV of zero.
  3. The sensitivity of each input variable is the percentage change from its forecast to the value which would result in a project NPV of zero.
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8
Q

What are the two calculations for sensitivity analysis? (linked to each other) (slide 6).

A
  1. Annual contribution = (unit price – unit cost) x sales volume
  2. NPV = (annual contribution x annuity Factor) – initial investment
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9
Q

What 3 actions should you take with sensitivity analysis based on the result?

A
  1. Accept risks and proceed; or
  2. Conduct further analysis into the riskiest input variables i.e. check assumptions, conduct market research; or
  3. Avoid risks and seek a better alternative
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10
Q

What should finance managers consider with sensitivity analysis?

A

But consider TIMING of and CONTROL over the input variables:

Most: initial investment, direct cost per unit
Least: sales volumes, selling price per unit, project life

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11
Q

What are the 4 limitations of sensitivity analysis?

A
  1. It cannot be used to compare different projects
  2. It only considers one input changing at a time
  3. It ignores the interdependency between inputs
  4. Considers extent but not the likelihood of risk
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12
Q

How does probability analysis overcome some limitations of sensitivity analysis?

A
  1. Evaluating both the extent and likelihood of project risk

2. Allowing the risk of different projects to be compared

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13
Q

What is the Expected net present value? (ENPV)

A

A corporate probability analysis which calculates the expected return of a projected and the risk (standard deviation) of a project.

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14
Q

What is the process of the ENPV?

A
  1. Calculate the NPV of a project under alternate future scenarios (i.e. levels of economic growth); and
  2. Assign probabilities to the likelihood of each scenario occurring (must total 100%)
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15
Q

What is the expected return of a project (In terms of ENPV).

A

The weighted average of its forecast outcomes under alternate scenarios.

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16
Q

How do you calculate the expected return (ENPV)?

A

ErA = Σ prA

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17
Q

How is the risk of the project measured and what’s it’s calculation? (ENPV)

A

BY THE STANDARD DEVIATION OF EXPECTED RETURNS

σA = √ (Σ p(ErA – rA)2)

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18
Q

What does the ENPV assume?

A

That the actual project returns will be normally distributed. A normal distribution can be defined by it’s expected return (Er) and it’s standard deviation (σA).

19
Q

What are the 4 outcomes once the ENPV is assummed?

A

Once assumed then actual probabilities can be assigned ranges of outcomes which can either be:

Highly likely, highly unlikely, probably, possible?

20
Q

What is it called when you compare project risk? (ENPV).

A

The coefficient of variation

21
Q

What is the calculation for the coefficient of variation?

A

CoV = σ ÷ Er

22
Q

What are the 3 benefits of the ENPV?

A
  1. Considers both extent and likelihood of risk.
  2. Enables comparison of risk of different projects
  3. Ensures managers consider alternate project outcomes under different scenarios
23
Q

what are the 3 drawbacks of the ENPV?

A
  1. The expected return is unlikely to be a discrete outcome
  2. Assumes returns are normally distributed
  3. Scenario probabilities are subjective
24
Q

Who founded Modern Portfolio Theory and what year?

A

Harry Markowitz 1952

25
Q

What is a portfolio?

A

A portfolio is a group of at least two constituents (i.e. securities, businesses or capital investment projects) under common ownership

26
Q

What does modern portfolio theory assume?

A

That investors make rational decisions based purely on:

Expected RETURNS; and
RISK, measured by the standard deviation of expected returns

27
Q

What do rational investors apply? (Modern portfolio theory)

A

MEAN VARIANCE ANALYSIS

28
Q

What 4 times do rational investors choose to apply mean variance analysis?

A
  1. Will choose an investment that has a higher expected return and a lower risk than another
  2. When two investments have the same expected return, will choose the investment that has the lowest risk
  3. When two investments have the same risk, will choose the investment that has the highest expected return
  4. When an investment has a lower risk and a lower return than another (and vice versa), the choice will depend on the investor’s degree of risk-aversion
29
Q

What does the extent of the portfolio effect (risk reduction) depend on?

A

The relative sizes of the constituents; and

The (expected and constant) correlation coefficients (ρ) between the returns of the constituents

30
Q

What 2 elements are within a portolio?

A

A portfolio has:

An expected return that is equal to the weighted average of its constituents’ expected returns; but

A standard deviation that is lower than the weighted average of its constituents’ standard deviations

31
Q

What 3 correlations coefficients (p) are between portfolio constituents?

A
  1. Perfect positive correlation (ρ = +1). Constituents are the same so no risk reduction
  2. Perfect negative correlation (ρ = -1) Constituents are opposites so highest risk reduction.

Intermediate correlation (-1 < ρ < +1). Constituents are similar (ρ > 0) or dissimilar (ρ ≤ 0). The level of risk reduction increases as the correlation coefficient falls from +1 to -1.

32
Q

What is the formula for the two asset portfolio? (slide 18 - 25)

A

BIG FUCKING FORMULA ON FORMULA SHEET.

33
Q

What considerations are there for when there are corporate portfolios?

A

The assumption of divisibility (and returns to scale) of corporate portfolio constituents

Directors choosing portfolios which match their shareholders’ level of risk aversion. However shareholders’ level of risk aversion is difficult to estimate and directors tend to be more risk averse than shareholders (an agency problem)

34
Q

What is the diversification debate?

A

When Security portfolio diversification (by investors) is much cheaper and quicker than corporate portfolio diversification (by directors). Directors may also lack the skills to effectively manage across a range of different sectors.

35
Q

What are the outcomes of the diversification debate\?

A

Unrelated corporate diversification (conglomeration) has become rare despite the portfolio effect. However related corporate diversification (expansion) is very common.

36
Q

What causes unsystematic risk?

A

Variability in returns over time due to factors specific to the company such as the sector(s) in which it operates in and its operating and financial efficiency.

37
Q

How can unsystematic risk by eliminated?

A

It can be largely eliminated by sufficient diversification (i.e. forming a portfolio containing at least 20 different securities)

Umbrellas and icecreams?

38
Q

What causes systematic risk? (Slide 30)

A

Variability in returns over time due to macro economic factors which affect all companies

Companies have different levels of systematic risk depending on their sensitivity to macro economic factors

It cannot be reduced by diversification

Accordingly, investors are rewarded for bearing systematic risk with a risk premium

39
Q

What is the CAPM?

A

An extension of portfolio theory.

40
Q

What are the 4 simplifying assumptions the CAPM makes?

A
  1. All investors hold fully diversified portfolios
  2. All investors have homogeneous expectations
  3. Investors can borrow and lend at a “risk-free rate”
  4. There are no taxes or transaction costs
41
Q

What does the CAPM propose?

A

A simple linear relationship between the risk and return of securities in a formula

42
Q

What does the CAPM formula look to find?

A

The expected (future) return of a security.

43
Q

What is the components of the CAPM Formula? (Slides 32 - 35)

A

On formula sheet.

ErL	=	Expected (future) return of a security
rF	=	Risk free rate
ErM	=	Expected return of the market portfolio
βL	=	Beta value of security
44
Q

What are the 4 drawbacks of the CAPM?

A
  1. Its simplifying assumptions
  2. Use of proxies for the risk free asset and the market portfolio
  3. Ex-ante theory
    uses historic data to predict future expected returns
  4. Beta (in)stability over time.

Corporate Finance Revision (10 decks)

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