FNCE30002 Lecture 11: Risk Management

Hi guys could someone help me and explain in detail the two fundamental principles of investments – the risk/return tradeoff and diversification. Also, describe how asset allocation and the correlation of various securities within asset classes impact the riskiness of an investor’s portfolio.

I found an answer but it seems to me very long and not sure about it so can you help me out guys

ANS:

Risk /Return Tradeoff

Risk, return and liquidity are three dimensions of investment decision. Risk/Return trade off considers two dimension ie risk and return. As risk of an investment increases , its expected return will decrease. Risk is measured by volatility of return which can be statistically obtained by standard deviation of return. Higher the standard deviation, higher will be volatility of return and higher the risk

Risk can be also measured as a relative risk compared to the market. This is measured by stock beta with reference to a market index. Higher the beta, higher the value of stock Beta, higher will be the risk .

Investors seeking higher return will need to take higher risks.

Treasury bonds are almost risk free assets. This has the lowest rate of return. Stocks have higher risk , hence have higher expected return. High beta stocks will have higher risk and higher returns.

An investor should understand his risk taking ability and will have to make a trade off between risk and return depending on his risk apetite.

Diversification:

There is a saying, do not put all your eggs in one basket. The reason is that it has higher risk if all eggs are in one basket. If the eggs are distributed in different basket, risk of loss decreases.

Same principle is applied in investment. Diversification reduces risk.

If one invests in different classes of assets like bonds, stock, commodities and properties –his risk is likely to reduce. Reduction in return in one asset is likely to be compensated by return in other asset.

Within one class of asset also, there should be diversification to reduce risk.

For example one stock “A “may have expected return of 10% and standard deviation of 5%.This risk can be reduced by diversification in number of assets and the ratio of Risk/return can be decreased.

If we diversify and instead of investing 100% in stock A, we invest 60% in “A” and 40% in another stock “B” having expected return15% and standard deviation of 8%.assume the correlation between the two assets are 0.5

Portfolio return=wa*Ra+wb*Rb

Wa=Weight of asset A=0.6

Wb=Weight of asset B=0.4

Ra=Return of A=10%

Rb=Return of B=15%

Sa=Standard deviation of A=5%

Sb=Standard deviation of B=8%

Corr(a,b)=Correlation of A & B=0.2

Portfolio return=0.6*10+0.4*15=12%

Portfolio Variance=(wa^2)*(Sa^2)+(wb^2)*(Sb^2)+2wa*wb*Cov(a,b)

Cov(a,b)=Corr(a,b)*Sa*Sb=0.1*5*8=4

Portfolio Variance=(0.6^2)*(5^2)+(0.4^2)*(8^2)+2*0.6*0.8*4=23.08

Portfolio standard deviation=Square root of Variance=(23.08^0.5)=4.8%

The diversification has increased return and reduced risk

Stock A was giving 10% return with 5% standard deviation. With diversification of portfolio we have 12% return and 4.8% standard deviation. Risk return ratio is decreased.

It may be noted that, higher the correlation between assets in the portfolio, higher will be risk in terms of standard deviation. Hence it is better to diversify with uncorrelated assets.

Diversification reduces unsystematic risk,but it cannot reduce systematic risk of overall market or economy

I need help with this problem i have. The company I chose was apple because i figured it would be the easiest. I know i listed the formulas, but i cant find any of the numbers. Can anyone possibly help? I need to know what numbers go in what formula.

Much appreciated.

Company Valuation

1. Analysis of WACC

a. Calculation of WACC for your company:

You will need to identify each component of the WACC formula and calculate the overall WACC.

The WACC formula for a company that uses debt and equity is as follows:

WACC = % Debt * Cost of Debt * (1 - Tax Rate) + % Equity * Cost of Equity

*You should use Yahoo! Finance and / or the company's most recent 10K report to identify all financial statement inputs. You can use the following guide for the inputs. The specific financial statement data are found on the relevant financial statement. Debt = Long-term Debt + Short-term Debt (on Yahoo! this is called, "Short/Current Long Term Debt")

Equity = Market Cap. (This is on the Key Statistics page in Yahoo! Finance)

% Debt = Debt / (Debt + Equity)

% Equity = 1 - % Debt

Cost of Debt = Interest Expense / Debt

Tax Rate = Income Tax Expense / Income Before Tax

Cost of Equity: Use the CAPM equation to calculate this

Cost of Equity = Risk free rate + Beta * (Market Risk Premium)

Risk free rate: look up the yield on 10 year US Treasury bonds

Beta: This is on the Key Statistics page in Yahoo! Finance

Market Risk Premium: Assume 11% minus the risk-free rate

b. Interpretation of WACC for Your Company

*Indicate what the WACC value you derived means for your company.

*What role does the WACC play for company managers when they are evaluating new projects to undertake?

*How would company managers and investors use the WACC for an overall company valuation analysis?

CAN SOMEONE PLEASE HELP>... I NEED ONLY the last two questions answered and I had posted thise twice! I NEED HELP>>>>>>>>>>>>>>>>>>>> PLEASE EXPLAIN THE PROCESS OF THE ANSWER...

Nike is the company chosen!

What is the company’s ticker symbol? Ticker = X

Find the amount of long-term debt (D): Publicly traded companies are required to produce annual accounting reports (10K) for the SEC detailing the financial operations of the past year. On the balance sheet, each company is required to list the value of long-term debt. (Note: Most of the tables in this report are created by accountants. Hence, this report provides book values. But, the book value of debt and the market value of debt are roughly equal.) These can be found on the SEC EDGAR webpage www.sec.gov/edgar.shtml. EDGAR stands for Electronic Data-Gathering, Analysis, and Retrieval system. Click “Search for Company Filings” then “Search by Company Name.”

Debt = X

Find the amount of equity (E):

What is the book value of equity? This can be found in the annual 10K report.

Book Value of Equity = X

What is the market value of equity? Several web pages list stock market information. All of this information can also be found on Bloomberg and Telemet using the terminals in the trading room. To find the information you need to find the amount of equity look in the Equity Research Category in the Key Stats and Company Financials Page. NOTE: Book equity and market equity are different!

Market Value of Equity = X

Use the answers to questions 2 and 3 to determine the market capital structure weights.

Weight of Debt = X

Weight of Equity = X

Estimate the cost of debt (r_D): You can find bond information for current bonds outstanding at the bond web page finra.org.

How many different bonds does the company currently have outstanding?

Number of bonds = X

What is the length of each bond?

Do the bonds have any special features (puts, calls, sinking funds, etc)?

What is the cost of debt of the most recently issued bond?

What do you think that the cost of debt will be if the company issues a new bond?

Estimate the cost of equity (r_E) two different ways:Dividend Growth Model

What is the current annual dividend (D₀)? On the Yahoo finance page follow the link for “Historical Prices” and then “Dividends Only.” This table can be exported into Excel to help you do calculations by clicking on “Download to Spreadsheet.”

Embed Excel Spreadsheet showing dividends for the last few years.

Current annual dividend = X

Determine the annual dividend for the past several years. Is there an approximate pattern to the dividends? Are the dividends constant, growing, or uneven?

If the dividends grow over time, find dividend growth (g).

g = X

Find the current stock price (P₀).

Using the information above calculate the cost of equity using the constant dividend model or the dividend growth model or state that neither one can be used.

Cost of Equity = X

Capital Asset Pricing Model

Several sources list β including Telemet and Bloomberg. Find β from 3 different sources. State which source you used. Why are the betas different from different sources?

Source 1 = X, β = X

Source 2 = X, β = X

Source 3 = X, β = X

Reason why betas are different.

Estimate β yourself.

Download the historical stock price of your company and use them to calculate returns.

Embed an Excel Spreadsheet showing the stock price and returns with only few lines showing.

Download the historical price of the S&P 500 index to use as an approximation of market performance. Use the prices to find returns.

Embed an Excel Spreadsheet showing the stock price and returns with only few lines showing.

Run a regression in which returns of the company are the dependent variable and S&P 500 index returns are the independent variable. Note: Your estimate of β should be very similar to the βs that you provided above. If it is very different, you are doing something wrong.

Show regression results.

β = X

Find R_f. What is the risk-free rate based on?

State the source of R_f

You can assume that Market Risk Premium is 6.1%. Using the information above, calculate the cost of equity using the CAPM.

Cost of Equity =

Based on your different estimates, what do you think that the cost of equity is?

Cost of Equity =

What is your company’s WACC?

Show the formula and numbers that you used to solve WACC.

WACC = X

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The company is considering a new project. At the end of the first year of the project they could earn net operating cash flow of $1 million, $2 million the following year and, $3 million in the last year. If the project requires an initial investment (upfront cost) of $5 million, would you advise them to accept the project? Why?

Show your work.

The company is considering a different project which could earn net operating cash flows of $500,000 per year for the next 10 years. The project costs $4 million. Would you advise them to accept the project? Why?

Show your work.