Risk and Return

Question 1

What is the return?

Answer 1

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

Question 2

What is the 2 elements within risk?

Answer 2

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

Question 3

What risk considerations attempt to do?

Answer 3

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

Question 4

What are the 4 risk evaluation methodologies?

Answer 4

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

Question 5

What is the rationale of sensitivity analysis?

Answer 5

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

Question 6

What is the outcome of sensitivity analysis?

Answer 6

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)

Question 7

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

Answer 7

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.

Question 8

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

Answer 8

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

Question 9

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

Answer 9

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

Question 10

What should finance managers consider with sensitivity analysis?

Answer 10

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

Question 11

What are the 4 limitations of sensitivity analysis?

Answer 11

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

Question 12

How does probability analysis overcome some limitations of sensitivity analysis?

Answer 12

1. Evaluating both the extent and likelihood of project risk

2. Allowing the risk of different projects to be compared

Question 13

What is the Expected net present value? (ENPV)

Answer 13

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

Question 14

What is the process of the ENPV?

Answer 14

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%)

Question 15

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

Answer 15

The weighted average of its forecast outcomes under alternate scenarios.

Question 16

How do you calculate the expected return (ENPV)?

Answer 16

ErA = Σ prA

Question 17

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

Answer 17

BY THE STANDARD DEVIATION OF EXPECTED RETURNS

σA = √ (Σ p(ErA – rA)2)

Question 18

What does the ENPV assume?

Answer 18

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).

Question 19

What are the 4 outcomes once the ENPV is assummed?

Answer 19

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

Highly likely, highly unlikely, probably, possible?

Question 20

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

Answer 20

The coefficient of variation

Question 21

What is the calculation for the coefficient of variation?

Answer 21

CoV = σ ÷ Er

Question 22

What are the 3 benefits of the ENPV?

Answer 22

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

Question 23

what are the 3 drawbacks of the ENPV?

Answer 23

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

Question 24

Who founded Modern Portfolio Theory and what year?

Answer 24

Harry Markowitz 1952

Question 25

What is a portfolio?

Answer 25

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

Question 26

What does modern portfolio theory assume?

Answer 26

That investors make rational decisions based purely on: Expected RETURNS; and RISK, measured by the standard deviation of expected returns

Question 27

What do rational investors apply? (Modern portfolio theory)

Answer 27

MEAN VARIANCE ANALYSIS

Question 28

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

Answer 28

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

Question 29

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

Answer 29

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

Question 30

What 2 elements are within a portolio?

Answer 30

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

Question 31

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

Answer 31

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.

Question 32

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

Answer 32

BIG FUCKING FORMULA ON FORMULA SHEET.

Question 33

What considerations are there for when there are corporate portfolios?

Answer 33

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)

Question 34

What is the diversification debate?

Answer 34

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.

Question 35

What are the outcomes of the diversification debate\?

Answer 35

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

Question 36

What causes unsystematic risk?

Answer 36

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.

Question 37

How can unsystematic risk by eliminated?

Answer 37

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

Question 38

What causes systematic risk? (Slide 30)

Answer 38

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

Question 39

What is the CAPM?

Answer 39

An extension of portfolio theory.

Question 40

What are the 4 simplifying assumptions the CAPM makes?

Answer 40

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

Question 41

What does the CAPM propose?

Answer 41

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

Question 42

What does the CAPM formula look to find?

Answer 42

The expected (future) return of a security.

Question 43

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

Answer 43

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 ```

Question 44

What are the 4 drawbacks of the CAPM?

Answer 44

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.