Week 6 Everything

Question 1

The expected cash flow

Answer 1

The expected cash flow is the weighted average of the possible cash flows outcomes such that the weights are the probabilities of the occurrence of the various states of the economy.

Question 2

Expected Cash flow (X)

Answer 2

(X) = ΣPbi*CFi

Where Pbi = probabilities of outcome i

CFi = cash flows in outcome i

Question 3

Holding-period return

Answer 3

payoff during the “holding” period.

Holding period could be any unit of time such as one day, few weeks or few years.

Question 4

Holding period gain =

Answer 4

Price end of period + cash distribution (dividend) - price beginning of period

Question 5

Expected Return example

Answer 5

You bought 1 share of Google for $524.05 on April 17 and sold it one week later for $565.06. Assuming no dividends were paid, your dollar gain was:

565.06 – 524.05 = $41.01

Therefore, Google rate of return:
41.01/524.05 = .0783 or 7.83%

Question 6

Measuring the Expected Return example 2

Answer 6

2 photos 10/4/19

Question 7

Expected Rate of Return

Answer 7

2 photos 10/4/19

Question 8

Risk involvement to the Expected Rate of Return

Three important questions:

Answer 8

What is risk?

How do we measure risk?

Will diversification reduce the risk of portfolio?

Question 9

Definition of Risk

Answer 9

Risk is the possibility of actual outcome deviating from what is expected. In the finance world, risk is linked to possibility of unexpected fluctuation in security prices, possibility of expected cashflow to materialize or possibility of achieving expected returns. Generally speaking, high levels of risk are associated with high potential returns. Commercially, risk types can be strategic, financial, legal, regulatory and operational risk. These may be individually assessed or as a combination.

Question 10

How can risk be measured

Answer 10

Risk refers to potential variability in future cash flows. The wider the range of possible future events that can occur, the greater the risk. Thus, the returns on common stock are more risky than returns from investing in a savings account in a bank. Risk can be measured as variability of actual returns from expected returns. Some common measures of risk are standard deviation and systematic risk.

Question 11

Consider two investment options:

Invest in Treasury bond that offers a 2% annual return.

Invest in stock of a local publishing company with an expected return of 14% based on the payoffs (given on next slide).

Answer 11

10/4/19

Treasury bond = 12% = 2%
Stock
= 0.1-10 + 0.25% + 0.415% + 0.225% + 0.130%
= 14%

We observe from above that the stock of the publishing company is more risky but it also offers the potential of a higher payoff.

Question 12

Standard deviation (S.D.) is one way to measure risk.

Answer 12

Standard deviation (S.D.) is one way to measure risk. It measures the volatility or riskiness of portfolio returns.

Question 13

S.D.

Answer 13

square root of the weighted average squared deviation of each possible return from the expected return.

Question 14

STANDARD DEVIATION

Answer 14

10/4/19 2 photos

Question 15

Five –step Procedure standard deviation

Step 1

Answer 15

Calculate the expected rate return of the investment, which was calculated previously to be 14 percent.

Question 16

Five –step Procedure standard deviation

Step 2

Answer 16

Subtract the expected rate of return of 14 percent from each of the possible rates of return and square the difference.

Question 17

Five –step Procedure standard deviation

Step 3

Answer 17

Multiply the squared differences calculated in step 2 by the probability that those outcomes will occur.

Question 18

Five –step Procedure standard deviation

Step 4

Answer 18

Sum all the values calculated in step 3 together. The sum is the variance of distribution of possible rate of return. Note that the variance is actually the average squared difference between the possible rates of return and the expected rate of return.

Question 19

Five –step Procedure standard deviation

Step 5

Answer 19

Take the square root of the variance calculated in step 4 to calculate the standard deviation of the distribution of possible rates of return.

Question 20

Five –step Procedure standard deviation example

Answer 20

2 photos 10/4/19

Question 21

How to interpret standard deviation as a measure risk?

Answer 21

The greater the standard deviation, greater is the variance between each return and the mean, indicating a greater risk. Blue chip vs speculative?

For a normal distribution of data …

68. 26% probability, actual data within 1 standard deviation of the mean.
69. 44% probability, actual data within 2 standard deviations of the mean.
70. 74% probability, actual data within 3 standard deviations of the mean.

Question 22

Comments on S.D.

Answer 22

There is a 68.27% probability that the actual returns will fall between 2.86% and 25.14% (= 14%  11.14%). So actual returns are far from certain!

Risk is relative; to judge whether 11.14% is high or low risk, we need to compare the S.D. of this stock to the S.D. of other investment alternatives.

To get the full picture, we need to consider not only the S.D. but also the expected return.

The choice of a particular investment depends on the investor’s attitude toward risk.

Question 23

Portfolio management and Diversification

Answer 23

Investors have various options to invest into different businesses or projects. Diversification helps to maximise the value of the company investments or project investments. In building a well diversified portfolio, the concern would be expected rate of return and risk of portfolio. Diversification can be achieved by investing in projects that are not related to existing investments i.e. returns from these projects move in the opposite direction.

Question 24

Total risk (σ ) =

Answer 24

Market risk (systematic) + Firm-specific risk (unsystematic risk)

Question 25

Systematic risk (denoted by β)

Answer 25

Type of risk causing variability of returns due to uncontrollable factors. External factors can be change in policies of the government, recession, inflation, political instability etc.

Question 26

Unsystematic risk

Answer 26

Type of risk causing variability of returns due to firm-specific factors such as management inefficiency, labour strike etc.

Question 27

Total Risk & Unsystematic Risk Decline as Securities Are Added

Answer 27

10/9/19

Question 28

CAPITAL ASSET PRICING MODEL

Answer 28

CAPM can be used to assess portfolio risk and to specify the rate of returns in order to evaluate different investments in a portfolio.

Question 29

CAPM Key points

Answer 29

Expected rate of return is equal to the risk-free rate of return plus a risk premium. β (non-diversifiable) is the relevant risk.

Question 30

CAPM equation:

Answer 30

r = rRF + b(rM - rRF)

r = Expected rate of return

b = Systematic risk

rRF = Risk free rate

(rM - rRF) = Risk premium

Question 31

CAPM – Is it suitable for project level investments too?

Answer 31

CAPM relies quite heavily on Beta and whilst it may help to understand an investment’s risk at a high level, it can sometimes lack the detail. It provides a high level direction to investment decisions however further tools might be utilized to better explain the return outcome of an investment. For project level decisions, specific analysis on various types of risk might be required to ascertain the suitability of investments.

Question 32

Risk Management

Answer 32

Risk management a very important contemporary theme of the twenty first century. Issues such as the global financial crisis and the BP oil spill. Rewards for successful risk-taking can be high but this must be balanced with management control systems to help mitigate risk. Risk profiling is essential for companies

Question 33

Pressure v Control

Answer 33

Corporate success is often achieved by innovation and a certain degree of risk taking. Managerial tensions between pressure for performance and control e.g. accounting fraud cases; sustainability-related crises. Systems should be structured to correctly manage but not entirely eliminate risk. That is, successful companies need to carefully balance innovation, management control and risk

Question 34

Developing a risk profile: Types of Risk

Answer 34

Strategic risk

Financial risk

Legal and regulatory risk

Operational risk

Question 35

Strategic risk

Answer 35

Associated with market-related activity and competitive dynamics, including threats from competitors and changes in technology such as technological innovations. Might also include measures of brand risk (brand erosion) and reputation risk

Question 36

Financial risk

Answer 36

such as the level of exposure to creditors and potential for a shortfall in liquidity

Question 37

Legal and regulatory risk

Answer 37

The exposure to and ability to comply with applicable and impending laws, and regulations in Australia and overseas. This includes “compliance” risk which is a major area of concern for most companies i.e. import duty, trading laws, contract liabilities; Occupational, Health & Safety (OH&S)

Question 38

Operational risk

Answer 38

anything that might damage the ability of an organisation to provide product or service offerings to customers.

Question 39

Strategic Investment and risk management

Answer 39

Both short and long-term management decisions should be examined for the potential impact any each of these risk categories. A company can be considered as a composite of all investment projects that it has undertaken. Capital investments include operational, regulatory and strategic investments. Investments should be examined not only on its individual intrinsic stand-alone benefit but also on the impact it has on its existing portfolio of investments

Question 40

Strategic Investments and cash flow uncertainties

Answer 40

Strategic investments are generally large outlays over long-time frames

Long timeframes reduce ability to anticipate:

Question 41

Strategic investments are generally large outlays over long-time frames

Answer 41

Ability to accurately estimate cash flows decreases as forecast moves further into future

Question 42

Long timeframes reduce ability to anticipate:

Answer 42

customer tastes; changes in technology; productivity; competition; availability of resources; changes in regulations;

interest rates; inflation; suitable discount rate

Question 43

Measuring Risk: A financial approach to strategic Investment Analysis

Answer 43

A key consideration for managers is how to incorporate risk in strategic investment decisions. Cash flows can be adjusted according to informal judgements or by using complex economic and statistical analyses

Question 44

Measuring Risk: A financial approach to strategic Investment Analysis

Financial Decision making tools include:

Answer 44

NPV, Sensitivity Analysis, Scenario Analysis;

Monte Carlo Simulation;

Capital Asset Pricing Model (CAPM)

Question 45

NPV: Present value of a series of cash flows

Answer 45

10/9/18

Question 46

Monte Carlo Simulation

Answer 46

Monte Carlo Simulation is a risk analysis technique in which probable future events are simulated on a computer, generating a probability distribution that indicates the most likely outcome. It is more complicated than scenario analysis resulting in hundreds of NPVs and a probability distribution for the project’s NPV values. It enables the decision maker with a better idea of the various outcomes that are possible from a single point estimate of the NPV

Question 47

Capital Asset Pricing Model (CAPM) pic

Answer 47

10/4/19

Question 48

How to manage & minimise the varying forms of risk?

Market-related strategic risk

Answer 48

Scanning the market and conducting periodic SWOT analysis to understand the dynamics. i.e. read financial newspapers daily to fully understand market; attend organisation meetings and events to network with peers/competitors.

Question 49

How to manage & minimise the varying forms of risk?

Reputation/brand-related strategic risks

Answer 49

Review all internal procedures and protocols (see next slide) to ensure safeguards are in place

Question 50

Operational risks - internal system checks:

Answer 50

Identify ‘input-process-output’ efficiency rates to check for and prevent surprises . Check impact of changes made on quality and quantity at each stage

Question 51

Managing risk: Setting appropriate internal controls

Answer 51

Structural safeguards

System safeguards

Staff safeguards

Question 52

Structural safeguards

Answer 52

Clear lines of hierarchical authority. Examples include the limits placed on a bank manager’s lending powers and prohibiting an accountant to handle cash

Question 53

System safeguards

Answer 53

Timely reporting, accurate recording and secure databases

Question 54

Staff safeguards

Answer 54

Employee recruitment and training to reach higher proficiency. Job rotation to reduce surprises (but must not break the clear lines of authority – provides opportunity). Special assignment

Question 55

Risk management: broad concepts of governance

Answer 55

Effective risk management includes broader external social and environmental impacts:

Sustainability and development

Question 56

IR

Answer 56

Integrated Reporting’ (IR) – a multifaceted single report underpinned by a ‘business model’ includes ‘natural capital’ as a potentially materially important capital

Question 57

Managing risk and internal governance:

Answer 57

Organisational culture and the ‘tone at the top’ (failure to uphold high ethical standards)

The CEO (dominant, charismatic and unchallenged).

The board of directors (weak, poor oversight)

Internal controls (not enough balance in earnings growth, individual initiative, and the CFO’s focus on ‘goal kicking’ versus ‘goal keeping’)