Filmore Enterprises| 2/13/2012 1

Case 84, fundamental concepts, Filmore Enterprises

FIN 471

Wassim Zhani

DR Eurico Ferreira
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ANSWER 1

A) Expected return of a stock represents the mean of a probability distribution of possible future returns
on the stock. Calculating the expected return for the stocks we find that:

Economy Prob. T-Bills T-Bonds CPC MORLEY EAT Index

------- ----- --------- -------- ----- ---- ---- -----
Recession 0.10 4.5% 10.0% -18.00% 18.00% -13.00% -13.00%
Below avg 0.20 4.5% 7.0% -8.00% 14.00% -6.00% -2.00%
Average 0.40 4.5% 5.0% 11.00% 6.00% 10.00% 11.00%
Above avg 0.20 4.5% 3.0% 26.00% -1.00% 20.00% 17.00%
Boom 0.10 4.5% 2.0% 35.00% -11.00% 30.00% 22.00%
----- --------- --------- --------- --------- --------- ---------
Expected return 4.50% 5.20% 9.70% 5.70% 8.50% 8.30%

Based solely on the data above, investment in CPC appears to be the best with an expected return of
9.70% while investment in T-Bills has the lowest expected return at 4.50%.General changes in the
economy have a direct effect on the expected returns. We find that during recessions, the best investment
is that of T-Bills and T-Bonds as they represent stability of returns. During this time, equity stocks have
low performance. During a boom period, the scenario is reversed where equity stocks are the best
performers with higher than normal returns. Bonds and Bills have a constant low return which remains
unchanged during a boom.

ANSWER 2

A) The T-Bill return does not depend on the state of the economy because the treasury must (and will)
redeem the bills at par regardless of the state of the economy. The T-Bills are risk free in the default risk
sense because the return will be realized in all possible economic states. However, it is important to note
that this return is composed of the real risk free rate, i.e. 3% plus an inflation premium of say 5%. As
there is uncertainty about inflation, it is unlikely that the realized real rate of return would equal the
expected 3%. If, for example, inflation averaged 6% over the year, then realized rate of return would be
only 8%-6% = 2%, not the expected 3%. Hence if we analyze in terms of purchasing power, T-Bills are
not riskless. T-Bills are also exposed to reinvestment rate risk. Hence they are not completely riskless.

B) Treasury bond returns change every day, because hardly anyone keeps them for the full term. Instead,
they are resold on the open market. Therefore, if you hear that bond prices dropped, then you know there
is not a lot of demand for Treasuries, and that returns must increase to compensate for lower demand. T-
Bond returns is considered by many investors to be a hedge against bad times and high inflation, so if the
stock market crashes, investors in this bond should do relatively well. T-Bill bonds are thus negatively
correlated with (move counter to) the economy.

C) Corporate bonds move with and are positively correlated with the economy. It will reflect the internal
performance of the company. In a boom, the firm sales and hence profit goes up. Hence these bonds
experience the same ups and downs as the economy. The bond rating also plays a predominant part in its
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returns. Bonds which are riskier have higher returns (albeit risky) as compared to bonds which are rated
high.

ANSWER 3

A)

Economy Prob. T-Bills T-Bonds CPC MORLEY EAT Index

------- ----- --------- -------- ----- ---- ---- -----
Recession 0.10 4.5% 10.0% -18.00% 18.00% -13.00% -13.00%
Below avg 0.20 4.5% 7.0% -8.00% 14.00% -6.00% -2.00%
Average 0.40 4.5% 5.0% 11.00% 6.00% 10.00% 11.00%
Above avg 0.20 4.5% 3.0% 26.00% -1.00% 20.00% 17.00%
Boom 0.10 4.5% 2.0% 35.00% -11.00% 30.00% 22.00%
----- --------- --------- --------- --------- --------- ---------
Expected return 4.50% 5.20% 9.70% 5.70% 8.50% 8.30%
Variance 0.0 5.0 257.2 65.8 161.9 103.4
Std deviation 0.00% 2.23% 16.04% 8.11% 12.72% 10.17%
Coef of var (CV) 0.00 0.43 1.65 1.42 1.50 1.23
Beta coefficient 0.00 -0.22 1.53 -0.77 1.22 1.00

B) The coefficient of variation (CV) is a standardized measure of dispersion about the expected value; it
shows the amount of risk per unit of return. When we measure risk per unit of return, CPC becomes the
most risky stock. The CV is a better measure of an assets stand-alone risk than Standard deviation
because CV considers both the expected value and the dispersion of a distributiona security with a low
expected return and a low standard deviation could have a higher chance of a loss than one with a high
standard deviation but a high expected return (as per normal risk return tradeoff). However, here we find
that CPC has both the highest expected return and the highest standard deviation. It is also the most risky
stock with the highest CV of 1.65. This is an apparent discrepancy within the risk return tradeoff
framework.
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ANSWER 4

A)+B)
NASDAQ Port:
Economy Prob. T-Bills T-Bonds CPC MORLEY EAT Index CPC-MORELY
------- ----- --------- -------- ----- ---- ---- ----- ---------
Recession 0.10 4.5% 10.0% -18.00% 18.00% -13.00% -13.00% 0.00%
Below
average 0.20 4.5% 7.0% -8.00% 14.00% -6.00% -2.00% 3.00%
Average 0.40 4.5% 5.0% 11.00% 6.00% 10.00% 11.00% 8.50%
Above
average 0.20 4.5% 3.0% 26.00% -1.00% 20.00% 17.00% 12.50%
Boom 0.10 4.5% 2.0% 35.00% -11.00% 30.00% 22.00% 12.00%
----- --------- --------- --------- --------- --------- --------- ---------
Expected return 4.50% 5.20% 9.70% 5.70% 8.50% 8.30% 7.70%
Variance 0.0 5.0 257.2 65.8 161.9 103.4 17.1
Std deviation 0.00% 2.23% 16.04% 8.11% 12.72% 10.17% 4.13%
Coef of var (CV) 0.00 0.43 1.65 1.42 1.50 1.23 0.54
Beta coefficient 0.00 -0.22 1.53 -0.77 1.22 1.00 1.00

From the above we can see that the standard deviation of the portfolio is way lower than that of the
individual stocks like CPC, Morley and EAT. This is because combining the two stocks diversifies away
some of the risk inherent in each stock if it were held in isolation, i.e., in a 1-stock portfolio.

Port: Port:
Economy Prob. CPC-MORELY CPC-EAT
------- ----- --------- ---------
Recession 0.10 0.00% -15%
Below average 0.20 3.00% -7%
Average 0.40 8.50% 10%
Above average 0.20 12.50% 22%
Boom 0.10 12.00% 32%
----- --------- ---------
Expected return 7.70% 9%
Variance 17.06 197.12
Std deviation 4.13% 14%
Coef of var (CV) 0.54 1.56
Beta coefficient 1.00 1.00
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C) If another portfolio of CPC-EAT were formed, the risk would go up substantially. Correlation
coefficient affects the level of diversification because in the real world stocks which are positively
correlated with each other, as the economy goes up, the stocks do well in general. Correlation coefficients
between stocks generally range from +0.5 - +0.7. A single stock selected on random would on average
have a standard deviation of around 35%. As additional stocks are added to the portfolio, the standard
deviation decreases because the stocks are not perfectly positively correlated. Hence correlation
coefficient affects level of diversification.

D) As the portfolio mix changes, this means that more and more of a risky stock is added and each
addition of stock has less of a risk reducing impact and eventually adding more of that stock has virtually
no affect on stabilizing the portfolios risk as measured by the standard deviation. This can be shown in a
table as below by varying the mix of the two stocks in the CPC-Morley portfolio.

Expected Std
CPC Morley return Variance deviation
0% 100% 6% 65.80 8%
10% 90% 6% 32.90 6%
20% 80% 7% 11.60 3%
30% 70% 7% 1.90 1%
40% 60% 7% 3.70 2%
50% 50% 8% 17.06 4%
60% 40% 8% 41.98 6%
70% 30% 9% 78.45 9%
80% 20% 9% 126.48 11%
90% 10% 9% 186.07 14%
100% 0% 10% 257.21 16%

ANSWER 5

As additional stocks are added to the portfolio, the standard deviation decreases because the stocks are not
perfectly positively correlated. However, as more and more randomly selected stocks are added each new
stock has less of a risk reducing impact and eventually adding more of that stock has virtually no affect on
the portfolios risk as measured by the standard deviation. In fact, standard deviation stabilizes at about
20.4% when 40 or more randomly selected stocks are added. Thus by combining stocks into a well
defined portfolio, investors can eliminate almost one half the riskiness of holding individual stocks. The
implication is evident: investors should hold well diversified portfolio of stocks rather than individual
stocks. This can be represented graphically as:
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ANSWER 6

A) Portfolio diversification affects an investors view of risk. A stocks stand alone risk as measured by its
standard deviation or coefficient of variation maybe important to an undiversified investor, but it is not
relevant to a well-diversified investor. A rational, risk-averse investor is more interested in the impact that
the stock has on the riskiness of his/her portfolio than on the stocks stand alone risk. Standalone risk is
composed of diversifiable risk which can be eliminated by holding the stock in a well diversified portfolio
and the risk that remains is called market risk because it is present even when the market portfolio is held.

B) If one holds a 1 stock portfolio, one will be exposed to a high degree of risk but one wont be
compensated for it. If the return were high enough to compensate for the high risk it would be a bargain
for more rational, diversified investors who in turn, would start buying this stock. These entire buy orders
would drive the stock price up and the return down. Thus in reality, there is no stock in the market with
returns high enough to compensate for its diversifiable risk.

C) The uncertainty associated with the returns generated from investing in an individual firms common
stock is known as diversifiable risk or un-systematic risk. This is the investment risk that is eliminated
through the holding of a well diversified portfolio. The economy wide uncertainty that all assets are
exposed to and cannot be diversified away is known as un-diversifiable risk. Often referred to as
systematic risk, beta risk, non-diversifiable risk, or the risk of the market portfolio. Total risk refers to the
sum of diversifiable and un-diversifiable risk.

D) The desire for diversification of individual retirement funds has an effect on the structure of US
investments. Desire for diversification lowers the risk but also leads to a lower expected rate of return
from those investments. Hence investments in the US might not look very lucrative if there exists a desire
to diversify funds for retirement.
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ANSWER 7

A)

Characteristic Lines
T-Bills, CPC, and MORELY
40.0%
30.0%
Realized Returns

20.0%
10.0%
0.0%
-10.0%
-20.0%
-30.0%
-15.00% -10.00% -5.00% 0.00% 5.00% 10.00% 15.00% 20.00% 25.00%

Realized Market Returns, kM

T-Bills T-Bonds CPC MORLEY EAT

NASDAQ T-
Year Index T-Bills Bonds CPC MORLEY EAT
- -
1 -13.00% 4.5% 10.0% 18.00% 18.00% 13.00%
2 -2.00% 4.5% 7.0% -8.00% 14.00% -6.00%
3 11.00% 4.5% 5.0% 11.00% 6.00% 10.00%
4 17.00% 4.5% 3.0% 26.00% -1.00% 20.00%
5 22.00% 4.5% 2.0% 35.00% -11.00% 30.00%
SLOPE 1.00 0.00 -0.22 1.53 -0.77 1.22
BETA 1.00 0.00 -0.22 1.53 -0.77 1.22

From the above we can see that the slope coefficients are similar to the betas of the stocks.

B) The distance between the plot points and regression line are known as errors or residuals. Residuals are
positive if the data point is above the line, or negative if the data point is below the line. Residuals are
measures of how bad the line is at prediction, so they should ideally be small. For any possible line,
theres a total badness equal to taking all the residuals, squaring them, and adding them up.

C) A stocks beta coefficient, , is a measure of the extent to which the returns on a given stock move
with the stock market as a whole (in most cases, a proxy for the market is used, such as the NASDAQ
stock index). Of course, there is more to it than that. Risk also implies return. Stocks with a high beta
should have a higher return than the market. If you are accepting more risk, you should expect more
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reward. For example, if the market with a beta of 1 is expected to return 8%, a stock with a beta of 1.5
should return 12%. If you dont see that level of return, then the stock is not a good investment
possibility. Stocks with a beta below 1 may be a safer investment (at least by this one measure) and you
should expect a lower return.

D)

NASDAQ
T-Bills T-Bonds CPC MORLEY EAT Index
Expected return 4.50% 5.20% 9.70% 5.70% 8.50% 8.30%
Beta coefficient 0.00 -0.22 1.53 -0.77 1.22 1.00

From the above table we can say that the risk return seems reasonably relative to the market. Stocks with
betas higher than the market, have a higher expected return hence higher risk and vice versa.

ANSWER 8

A)

Plotting for Security Market Line

Required Rate of Return

25.0%
20.0%
15.0%
10.0%
5.0%
0.0%
-2.00-1.75-1.50-1.25-1.00-0.75-0.50-0.25 0.00 0.25 0.50 0.75 1.00 1.25 1.50 1.75 2.00

Risk (beta)

SML

B)

Rf Rm Beta ROR Expected Return

CPC 5.20% 8.30% 1.53 9.96% 9.70%
Morley 5.20% 8.30% -0.77 2.80% 5.70%
EAT 5.20% 8.30% 1.22 8.99% 8.50%

The decision to buy or sell the stock will depend on the difference between ROR and expected return. If
ROR<Expected Return, then a buy decision is triggered. The converse applies for sell decisions.
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C) The stocks are not in equilibrium. They can be brought into equilibrium buy the necessary buy/sell
market corrections in order to equalize the ROR with expected return.

ANSWER 9

A)

Rf Rm Beta ROR Expected Return

40CPC:60 EAT 5.20% 8.30% 1.00 8.30% 8.98%

From the above table we see that the required rate of return for a 40:60 mix in portfolio CPC-EAT is
lower than the expected return. Hence this stock would be purchased because my hurdle rate is 8.30%
anything that fetches me over and above that rate will be accepted.

B) If Kathy and Randy provided a greater share of the upfront capital so that the long term debt ratio was
lower this would mean lower leverage to the company. Lower leverage would in turn lower the level of
risk and subsequent lower return on equity. Hence the decision to infuse more equity reduces the risk
element in the firm.

ANSWER 10

A)

If we bring in 3% inflation
Rf Rm Beta ROR Expected Return
CPC 8.20% 11.30% 1.53 12.96% 9.70%
Morley 8.20% 11.30% -0.77 5.80% 5.70%
EAT 8.20% 11.30% 1.22 11.99% 8.50%

Here we have plotted the SML for various betas of the companies. The base case SML is based on an Rf
= 5.20% and an Rm =8.30%. If inflation expectation increase by 3% with no change in risk aversion then
the entire SML is shifted upwards (parallel to the base SML) by 3%. Hence all securities returns increase
accordingly. In case of high risk securities a small shift in SML upwards leads to a more than proportional
shift in the required rate of return. In case of low risk securities, a small shift in SML leads to a less than
proportional increase in ror.

B)

If we bring in 4% risk aversion

Expected
Rf Rm Beta ROR Return
CPC 5.20% 12.30% 1.53 16.09% 9.70%
Morley 5.20% 12.30% -0.77 -0.30% 5.70%
EAT 5.20% 12.30% 1.22 13.87% 8.50%
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When investor risk aversion increases, this causes the SML to rotate upward about the Y-Intercept. Rf
still remains constant at 5.20% but now Rm increase to 12.30% and total market risk premium is 7.1%.
The effect of this is that the required rate of return will rise sharply on high risk (high beta) stocks and not
much on low risk (low beta stocks)

All this is reflected on a graph as below:

Changes to Security Market Line

Required Rate of Return

25.0%
20.0%
15.0%
10.0%
5.0%
0.0%
- - - - - - - - 0.00 0.25 0.50 0.75 1.00 1.25 1.50 1.75 2.00
2.00 1.75 1.50 1.25 1.00 0.75 0.50 0.25
Risk (beta)

SML 3% Inflation 3% Risk Premium

C)

Though an increase in inflation leads to lower returns in the short run for low risk stocks, in the long run
this gets corrected. However an increase in risk aversion is a more lasting change and can tend to move
into the long run too.

ANSWER 11

A)

It is important for operating managers to be cognizant of the way investors look at risk because
companies obtain their investment funds from investors who buy the firms stocks and bonds. When
investors buy these securities, they require a risk premium which is based on the companys risk as they
(investors) see it. Further since investors in general hold well diversified portfolios of stocks and bonds.,
the risk that is relevant to them is the securitys market risk not its stand alone risk. Thus investors view
the risk of a firm from a market risk perspective.

B)

Situation: A particular decision appears risky to investors but the firm know it is not risky

If project can be financed with internal funds, therefore the firm does not need to sell securities to
undertake the project In this case, as investors think the project to be risky, they will charge a higher
cost of equity. If internal financing is available then the manager should opt for it as it is not feasible to
approach investors due to their perception.
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The project is very large and securities must be sold to finance it In this case, the firm has no option but
to reject the investment decision if the cost of equity > rate of return from project.

The project is long term and therefore it will take years for the company to receive cash flows within a
few months - The Company might accept the project as the managers know it is not very risky project and
though a gestation period is present, certainty of cash flows exist

Project is short term, so the company will complete it and receive cash flows within a few months In
this case even if cash flows are incoming, the company might not be able to accept the project due to the
high risk perception of investors.

Situation: A particular decision appears safe to investors but the firm knows it is risky

If project can be financed with internal funds, therefore the firm does not need to sell securities to
undertake the project In this case, as investors think the project to be safe, they will charge a lower cost
of equity. Even if internal financing is available the manager should not opt for it as it is more feasible to
approach investors due to the low cost of funds and its availability

The project is very large and securities must be sold to finance it In this case, the firm has no option but
to accept the investment decision if the cost of equity > rate of return from project.

The project is long term and therefore it will take years for the company to receive cash flows within a
few months - The Company might reject the project as the managers know it is a very risky project and
the presence of a gestation period is present makes the certainty of cash flows doubtful.

Project is short term, so the company will complete it and receive cash flows within a few months In
this case the cash flows are incoming, the company might be able to accept the project due to the low risk
perception of investors.