Chapter 16 RISK ANALYSIS QUESTIONS AND ANSWERS Q16.1 Q16.

1 In economic terms, what is the difference between risk and uncertainty? ANSWER Economic risk is the chance of loss because all possible outcomes and their probability of happening are unknown. Actions taken in such a decision environment are purely speculative, such as the buy and sell decisions made by traders and other speculators in commodity, futures, and options markets. All decision makers are equally likely to profit as well as to lose; luck is the sole determinant of success or failure. Uncertainty exists when the outcomes of managerial decisions cannot be predicted with absolute accuracy but all possibilities and their associated probabilities are known. Under conditions of uncertainty, informed managerial decisions are possible. Experience, insight, and prudence allow managers to devise strategies for minimizing the chance of failing to meet business objectives. Although luck still plays a role in determining ultimate success, managers can deal effectively with an uncertain decision environment by limiting the scope of individual projects and developing contingency plans for dealing with failure. Q16.2 Domestic investors sometimes miss out on better investment opportunities available to global investors. At the same time, global investors face special risks. Discuss some of the special risks faced by global investors. ANSWER Cultural risk is borne by companies that pursue a global investment strategy. Product market differences due to distinctive social customs make it difficult to predict which products might do well in foreign markets. For example, breakfast cereal is extremely popular and one of the most profitable industries in the United States, Canada, and the United Kingdom. However, in France, Germany, Italy, and many other foreign countries, breakfast cereal is less popular and less profitable. In business terms, breakfast cereal doesn't "travel" as well as U.S.-made entertainment like movies and television programming. Currency risk is another important danger facing global businesses because most companies wish to eventually repatriate foreign earnings back to the domestic parent. When the U.S. dollar rises in value against foreign currencies such as the Canadian dollar, foreign profits translate into fewer U.S. dollars. Conversely, when the U.S. dollar falls in value against the Canadian dollar, profits earned in Canada

Q16.2

241

Chapter 16 translate into more U.S. dollars. Because price swings in the relative value of currencies are unpredictable and can be significant, many multinational firms hedge against currency price swings using financial derivatives in the foreign currency market. This hedging is not only expensive but can be risky during volatile markets. Global investors also experience government policy risk because foreign government grants of monopoly franchises, tax abatements, and favored trade status can be tenuous. In the "global friendly" 1990s, many corporate investors seem to have forgotten the widespread confiscations of private property owned by U.S. corporations in Mexico, Cuba, Libya, the former Soviet Union, and in a host of other countries. Expropriation risk, or the risk that business property located abroad might be seized by host governments, is a risk that global investors must not forget. During every decade of the twentieth century, U.S. and other multinational corporations have suffered from expropriation and probably will in the years ahead.

Q16.3

The standard deviation measure of risk implicitly gives equal weight to variations on both sides of the expected value. Can you see any potential limitations of this treatment? ANSWER Yes. If investors had a constant marginal utility for money, then random gains, the segment of the probability distribution to the right of the expected value, would be weighted equally with random losses, the segment of the distribution to the left of the expected value. This equality of random gains and losses would produce indifference to risk, making formal risk analysis unnecessary. However, empirical evidence argues that many, if not most, investors display investing behavior which can only be described as risk averse. These investors place a greater weight on downside versus upside return variation. This fact reduces the value of the standard deviation measure as an indicator of risk.

Q16.3

Q16.4

Confronted with a choice between $50 today or $100 one year from now, economic experiments suggest that the vast majority of people will take will take the $50 today. At the same time, economic experiments show that most people will opt to take $100 in ten years over $50 in nine years. Is such behavior rational? Explain why or why not. ANSWER No, it is not rational when confronted with a choice between $50 today or $100 one year from now to take the $50 today, but opt to take $100 in ten years over $50 in nine years. Psychologists argue that almost everyone is subject to this defect of human reasoning, an irrational bias referred to as temporal myopia. Instead of inspiring caution, the human brains typical response to uncertainty is to sharply reduce the importance of the distant future in decision-making, an effect known as hyperbolic

Q16.4

Risk Analysis

242

discounting. Studies show that consequences that occur at a later time, good or bad, tend to have a lot less bearing on choices the more distantly they fall in the future. If someone were to offer the choice between $50 right now or $100 tomorrow, the latter would seem the clear choice. But as the delay gap widens, the importance of the extra $50 quickly diminishes for most people, despite the fact that its actual value is constant. Confronted with a choice between $50 today or $100 one year from now, the vast majority will take the $50. Once a certain time threshold is crossed, however, the devaluing effect of time diminishes. Experiments show that most people will opt to take $100 in ten years over $50 in nine years. In essence, hyperbolic discounting is the human tendency to prefer smaller payoffs now over larger payoffs later, which leads one to largely disregard the future when it requires sacrifices in the present. Q16.5 State-run lotteries commonly pay out 50 percent of total lottery ticket sales in the form of jackpots and prizes. Use the certainty equivalent concept to quantify the minimum value placed on each risky dollar of expected return by lottery ticket buyers. Why are such lotteries so popular? ANSWER Any expected risky amount can be converted to an equivalent certain sum using the certainty equivalent adjustment factor, , calculated as the ratio of a certain sum divided by an expected risky amount, where both dollar values provide the same level of utility. The certain sum numerator and expected return denominator may vary in dollar terms, but they provide the exact same reward in terms of utility. In the case of state-run lotteries, in which a certain sum of $1 (the lottery ticket price) provides same utility as an expected risky return of 50, the certainty equivalent adjustment factor = 2 = $1/$0.50. This means that the "price" of one dollar in risky expected return is 50 in certain dollar terms. Lotteries have proven wildly popular. This suggests that for small dollar amounts many consumers are risk-seeking in their behavior. This is particularly true in the case of the elderly and the uneducated. Apparently, such consumers place a very high price on the small and unlikely chance of winning a substantial amount. Q16.6 Q16.6 Graph the relation between money and its utility for an individual who buys both household fire insurance and state lottery tickets. ANSWER In buying household fire insurance, individuals display risk averse behavior when faced with the small probability of a catastrophic loss. This implies a concave-to-theorigin relation between money and its utility for losses. Conversely, the purchase of state-run lottery tickets is consistent with risk seeking behavior when faced with the small probability of a huge windfall gain -- given that the amount placed at risk (the lottery ticket cost) is relatively insignificant. This implies a convex-to-the-origin relation between money and its utility at high levels of wealth. Prospect theory,

Q16.5

243

Chapter 16 developed by Daniel Kahneman and Amos Tversky as a realistic alternative to expected utility theory, describes how loss averse individuals will display an s-shaped utility function relative to some base or reference point.

Q16.7 Q16.7

When the basic valuation model is adjusted using the risk-free rate, i, what economic factor is being explicitly accounted for? ANSWER When the basic valuation model is adjusted using the risk-free rate i, the time value of money or cost of postponing consumption is being explicitly accounted for.

Q16.8 Q16.8

If the expected net present value of returns from an investment project is $50,000, what is the maximum price that a risk-neutral investor would pay for it? Explain. ANSWER $50,000. A risk neutral investor places a maximum value on a project in an amount exactly equal to the expected return. Therefore, risk neutral investors ignore risk in project evaluation. If this seems anomalous, it is only because most studies find investors are risk averse rather than risk neutral.

Q16.9

Market estimates of investors reactions to risk cannot be measured precisely, so it is impossible to set risk-adjusted discount rates for various classes of investment with a high degree of precision. Discuss this statement.

Risk Analysis Q16.9

244

ANSWER This statement has considerable validity. It is impossible to precisely measure an individuals attitude to risk, and the problem is further compounded by the conceptual necessity of aggregating individual risk indifference curves to form a market risk indifference curve. Further, even if it were possible to make the required estimates at a given point in time, it would be difficult to use these estimates for long-run planning purposes. Furthermore, investor attitudes to risk depend on psychological factors which vary over time. Despite these practical difficulties, the logic of the concept is appealing, and one must ask the question: Is it better to make subjective estimates and to construct an imperfect set of risk-adjusted discount rates for use in evaluating assets with different degrees of risk, or is it preferable to use a constant discount rate for all projects? It is often preferable to make an admittedly imprecise estimate of the appropriate risk-adjusted discount rate rather than to assume that no differences exist. And finally, market estimates of investor attitudes toward risk can be inferred for the firm as a whole based upon the values investors place on the firms debt and equity securities. If the return offered bond and stockholders is too low given the level of risk encountered, bond and stock prices will fall. If the return offered is high given investor risk expectations, bond and stock prices will rise. What is the value of decision trees in managerial decision making? ANSWER Decision trees are like road maps. They provide a means for plotting ones alternatives in a decision problem and determining where each alternative leads.

Q16.10 Q16.10

SELF-TEST PROBLEMS AND SOLUTIONS ST16.1 Certainty Equivalent Method. Courtney-Cox, Inc., is a Texas-based manufacturer and distributor of components and replacement parts for the auto, machinery, farm, and construction equipment industries. The company is presently funding a program of capital investment that is necessary to reduce production costs and thereby meet an onslaught of competition from low-cost suppliers located in Mexico and throughout Latin America. Courtney-Cox has a limited amount of capital available and must carefully weigh both the risks and potential rewards associated with alternative investments. In particular, the company seeks to weigh the advantages and disadvantages of a new investment project, project X, in light of two other recently adopted investment projects, project Y and project Z: Expected Cash Flows After Tax (CFAT) Per Year Year Project X Project Y Project Z

245

Chapter 16

Expected Cash Flows After Tax (CFAT) Per Year Year 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 Investment Outlay in 2000: A. B. C. Project X $10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 $60,000 Project Y $20,000 18,000 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 $91,131 $60,000 Project Z $0 2,500 5,000 7,500 10,000 12,500 15,000 17,500 20,000 22,500 $79,130 $50,000

PV of Cash Flow @ 5 percent

Using a 5 percent risk-free rate, calculate the present value of expected cash flows after tax (CFAT) for the ten-year life of project X. Calculate the minimum certainty equivalent adjustment factor for each projects CFAT that would justify investment in each project. Assume that the management of Courtney-Cox is risk averse and uses the certainty equivalent method in decision making. Is project X as attractive as or more attractive than projects Y and Z? If the company would not have been willing to invest more than $60,000 in project Y nor more than $50,000 in project Z, should project X be undertaken?

D. ST16.1 .

SOLUTION Using a 5 percent risk-free rate, the present value of expected cash flows after tax (CFAT) for the ten-year life of Project X is $77,217, calculated as follows:

Risk Analysis

246

Expected Cash Flows After Tax (CFAT) Per Year PV of $1 Year 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 Project X $10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 at 5 percent 0.9524 0.9070 0.8638 0.8227 0.7835 0.7462 0.7107 0.6768 0.6446 0.6139 PV of CFAT at 5 percent $9,524 9,070 8,638 8,227 7,835 7,462 7,107 6,768 6,446 6,139 $77,217

PV of Cash Flow @ 5 percent B.

To justify each investment alternative, the company must have a certainty equivalent adjustment factor of at least X = 0.777 for project X, Y = 0.658 for project Y, and Z = 0.632 for project Z, because: = Certain Sum Expected Risky Sum Investment Outlay (Opportuni ty cost) Present Value CFAT

Project X $60,000 = 0.777 $77,217

Project Y

247 $60,000 = 0.658 $91,131

Chapter 16

Project Z $50,000 = 0.632 $79,130

In other words, each risky dollar of expected profit contribution from project X must be worth at least (valued as highly as) 77.7 in certain dollars to justify investment. For project Y, each risky dollar must be worth at least 65.8 in certain dollars; each risky dollar must be worth at least 63.2 to justify investment in project Z. C. Given managerial risk aversion, project X is the least attractive investment because it has the highest price on each risky dollar of expected CFAT. In adopting projects Y and Z, Courtney-Cox implicitly asserted that it is willing to pay between 63.2 (project Z) and 65.8 (project Y) per each expected dollar of CFAT. No. If the prices described previously represent the maximum price the company is willing to pay for such risky returns, then project X should not be undertaken. Project Valuation. The Central Perk Coffee House, Inc., is engaged in an aggressive store refurbishing program and is contemplating expansion of its in-store baking facilities. This investment project is to be evaluated using the certainty equivalent adjustment factor method and the risk-adjusted discount rate method. If the project has a positive value when both methods are employed, the project will be undertaken. The project will not be undertaken if either evaluation method suggests that the investment will fail to increase the value of the firm. Expected cash flow after tax (CFAT) values over the five-year life of the investment project and relevant certainty equivalent adjustment factor information are as follows: In-store Baking Facilities Investment Project Time Period (Years) 0 1 2 Project E(CFAT) ($75,000) 22,500 25,000

D. ST16.2

Alpha 1.00 0.95 0.90

Risk Analysis

248

In-store Baking Facilities Investment Project Time Period (Years) 3 4 5 Project E(CFAT) 27,500 30,000 32,500

Alpha 0.85 0.75 0.70

Total $62,500 At the present time, an 8 percent annual rate of return can be obtained on short-term U.S. government securities; the company uses this rate as an estimate of the risk-free rate of return. A. B. Use the 8 percent risk-free rate to calculate the present value of the investment project. Using this present value as a basis, use the certainty equivalent adjustment factor information given previously to determine the risk-adjusted present value of the project. Use an alternative risk-adjusted discount rate method of project valuation on the assumption that a 15 percent rate of return is appropriate in light of the level of risk undertaken. Compare and contrast your answers to parts B and C. Should the investment be made?

C.

D. ST16.2 A.

SOLUTION The present value of this investment project can be calculated easily using a handheld calculator with typical financial function capabilities or by using the tables found in Appendix B. Using the appropriate discount factors corresponding to an 8 percent risk-free rate, the present value of the investment project is calculated as follows: Hot Food Carryout Counter Investment Project Time Period (Years) 0 1 2 Present Value of $1 at 8 percent 1.0000 0.9259 0.8573 Project E(CFAT) ($75,000) 22,500 25,000 Present Value of E(CFAT) at 8 percent ($75,000) 20,833 21,433

249

Chapter 16

Hot Food Carryout Counter Investment Project Time Period (Years) 3 4 5 Total B. Present Value of $1 at 8 percent 0.7938 0.7350 0.6806 Project E(CFAT) 27,500 30,000 32,500 $62,500 Present Value of E(CFAT) at 8 percent 21,830 22,050 22,120 $33,266

Using the present value given in part A as a basis, the certainty equivalent adjustment factor information given previously can be employed to determine the risk-adjusted present value of the project:
In-store Baking Facilities Investment Project Time Period (Years) 0 1 2 3 4 5 Total Present Value of $1 at 8 percent 1.0000 0.9259 0.8573 0.7938 0.7350 0.6806 Project E(CFAT) ($75,000) 22,500 25,000 27,500 30,000 32,500 $62,500 Present Value of E(CFAT) at 8 percent ($75,000) 20,833 21,433 21,830 22,050 22,120 $33,266 Risk-Adjusted Value ($75,000) 19,791 19,290 18,556 16,538 15,484 $14,659

Alpha 1.00 0.95 0.90 0.85 0.75 0.70

C.

An alternative risk-adjusted discount rate method of project valuation based on a 15 percent rate of return gives the following project valuation: In-store Baking Facilities Investment Project Time Period (Years) 0 1 2 3 4 5 Total Present Value of $1 at 15 percent 1.0000 0.8696 0.7561 0.6575 0.5718 0.4972 Project E(CFAT) ($75,000) 22,500 25,000 27,500 30,000 32,500 $62,500 Present Value of E(CFAT) at 15 percent ($75,000) 19,566 18,903 18,081 17,154 16,159 $14,863

Risk Analysis

250

D.

The answers to parts B and C are fully compatible; both suggest a positive riskadjusted present value for the project. In part B, the certainty equivalent adjustment factor method reduces the present value of future receipts to account for risk differences. As is typical, the example assumes that money to be received in the more distant future has a greater risk, and hence, a lesser certainty equivalent value. In the risk-adjusted discount rate approach of part C, the discount rate of 15 percent entails a time-factor adjustment of 8 percent plus a risk adjustment of 7 percent. Like the certainty equivalent adjustment factor approach, the risk-adjusted discount rate method gives a risk-adjusted present value for the project. Because the risk-adjusted present value of the project is positive under either approach, the investment should be made.

PROBLEMS AND SOLUTIONS P16.1 Risk Preferences. Identify each of the following as being consistent with risk-averse, risk-neutral, or risk-seeking behavior in investment project selection. Explain your answers. A. B. C. D. E. P16.1 A. B. Larger risk premiums for riskier projects Preference for smaller, as opposed to larger, coefficients of variation Valuing certain sums and expected risky sums of equal dollar amounts equally Having an increasing marginal utility of money Ignoring the risk levels of investment alternatives

SOLUTION Risk-averse investors demand higher risk premiums as project risk levels increase. Risk-averse investors place a relatively low value on small probabilities of a high payoff. As a result, they prefer a lower standard deviation in project returns, holding expected return constant, and, therefore, lower as opposed to higher coefficients of variation (risk-reward ratios). Risk-neutrality implies that a given decision maker places a value on an investment project that is just equal to the project expected return. Therefore, certain sums and expected risky sums of equal dollar amounts are valued equally.

C.

251 D.

Chapter 16 Risk-seeking investors display behavior consistent with an increasing marginal utility of money because increases in income or wealth provide more than proportionate increases in well-being, these individuals display very aggressive investment behavior. Risk-neutrality results in a value being placed on individual projects equal to their expected return, irrespective of the underlying variability in returns. Certainty Equivalents. The certainty equivalent concept can be widely employed in the analysis of personal and business decision making. Indicate whether each of the following statements is true or false and explain why: A. The appropriate certainty equivalent adjustment factor, , indicates the minimum price in certain dollars that an individual should be willing to pay per risky dollar of expected return. If 1, a certain sum and a risky expected return of different dollar amounts provide equivalent utility to a given decision maker. If previously accepted projects with similar risk have s in a range from = 0.4 to = 0.5, an investment with an expected return of $150,000 is acceptable at a cost of $50,000. A project for which NPV > 0 using an appropriate risk-adjusted discount rate has an implied factor that is too large to allow project acceptance. State lotteries that pay out 50 percent of the revenues that they generate require players who place at least a certain $2 value on each $1 of expected risky return.

E. P16.2

B. C.

D. E.

P16.2 A. B.

SOLUTION False. The certainty equivalent adjustment factor indicates the maximum price in certain dollars that an individual is willing to pay per risky dollar of expected return. True. The factor is the ratio of a certain sum divided by an expected risky amount that are equivalent in terms of utility, but may differ in strict dollar terms, as in the case of 1. True. If similar projects implicitly involve =s in a range from = 0.4 to = 0.5, then the maximum certain sum equivalent of an expected risky $150,000 falls in the range between $60,000 (= 0.4 $150,000) and $75,000 (= 0.5 $150,000), because:

C.

Risk Analysis Certain sum Expected risky amount

252

Certain sum

= Expected risky amount

Therefore, a project cost of $50,000 would not only be acceptable, but represents a bargain! D. False. A project which has NPV > 0 using the risk adjusted discount rate approach has an factor below the maximum acceptable level. Such a project will be desirable, because it has a price per risky dollar of return below that necessary to induce investment. True. State lotteries that pay back 50 percent of the amount bet involve players who have an 2. Expected Value. Perry Chandler, a broker with Caveat Emptor, Ltd., offers free investment seminars to local PTA groups. On average, Chandler expects 1 percent of seminar participants to purchase $25,000 in tax-sheltered investments and 5 percent to purchase $5,000 in stocks and bonds. Chandler earns a 4 percent net commission on tax shelters and a 1 percent commission on stocks and bonds. Calculate Chandlers expected net commissions per seminar if attendance averages ten persons. SOLUTION Expected net commissions will be the sum of net commissions on tax shelters (TS) and stocks and bonds (S&B). E(NCTS) = Expected Sales Commission Rate = (0.01)($25,000)(10) (0.04) = $100 E(NCS&B) = Expected Sales Commission Rate = (0.05)($5,000)(10) (0.01) = $25 E(NC) = E(NCTS) + E(NCS&B) = $100 + $25

E. P16.3

P16.3 A.

253 = $125 P16.4

Chapter 16

Probability Concepts. Firefly Products, Inc., has just completed development of a new line of skin-care products. Preliminary market research indicate two feasible marketing strategies: (1) creating general consumer acceptance through media advertising or (2) creating distributor acceptance through intensive personal selling. Sales estimates for under each marketing alternative are:
Media Advertising Strategy Probability 0.1 0.4 0.4 0.1 Sales $500,000 1,500,000 2,500,000 3,500,000 Probability 0.3 0.4 0.3 Personal Selling Strategy Sales $1,000,000 1,500,000 2,000,000

A.

Assume that the company has a 50 percent profit margin on sales (that is, profits equal one-half of sales revenue). Calculate expected profits for each plan. Construct a simple bar graph of the possible profit outcomes for each plan. Which plan appears to be riskier? Assume that managements utility function resembles the one illustrated in the following figure. Calculate expected utility for each strategy. Which strategy should the marketing manager recommend?

B. C.

P16.4 A.

SOLUTION

Media Advertising Strategy Probability (1) 0.1 0.4 0.4 0.1 1.0 Personal Selling Strategy Probability (1) 0.3 0.4 0.3 1.0 Sales (2) $1,000,000 1,500,000 2,000,000 Profit (3) = (2) 0.5 $500,000 750,000 1,000,000 (4) = (3) (1) $150,000 300,000 300,000 E(PS) = $750,000 Sales (2) $500,000 1,500,000 2,500,000 3,500,000 Profit (3) = (2) 0.5 $250,000 750,000 1,250,000 1,750,000 (4) = (3) (1) $25,000 300,000 500,000 175,000 E(MA) = $1,000,000

B.

Strategy 1: Media Advertising Strategy

Probability (Pr) 0.5 0.4 0.3 0.2 0.1 0.0
50 00 50 0 0 0 ,5 0 $1
$1,500

,0 0

,2 5

$2

$5

$7

$1

$1

Total Profit ($000)

Probability (Pr) 0.5 0.4 0.3 0.2 0.1 0.0 $250

Strategy 2: Personal Selling Strategy

$500

$750

$1,000

$1,250

Total Profit ($000)

$1
$1,750

,7 5

The media advertising strategy appears more risky than the personal selling strategy because of the greater variability of possible outcomes. C. Media Advertising Strategy Probability (1) 0.1 0.4 0.4 0.1 1.0 Personal Selling Strategy Probability (1) 0.3 0.4 0.3 1.0 Profits (2) $500,000 750,000 1,000,000 Utils (3) 70.0 82.5 90.0 (4) = (3) (1) 21 33 27 E(U) = 81 Profits (2) $250,000 750,000 1,250,000 1,750,000 Utils (3) 50.0 82.5 95.0 100.0 (4) = (3) (1) 5 33 38 10 E(U) = 86

The marketing manager should recommend the media advertising strategy because of its higher expected utility. In this instance, the higher expected profit of this strategy more than offsets its greater risk. P16.5 Probability Concepts. Narcissism Records, Inc., has just completed an agreement to re-release a recording of The Bosss Greatest Hits. The Boss had a number of hits on the rock and roll charts during the early 1980s. Preliminary market research indicates two feasible marketing strategies: (1) concentration on developing general consumer acceptance by advertising on late-night television or (2) concentration on developing distributor acceptance through intensive sales calls by company representatives. Estimates for sales under each alternative plan and payoff matrices according to an assessment of the likelihood of product acceptance under each plan are as follows: Strategy 1 Consumer Television Promotion Strategy 2 Distributor Oriented Promotion

Probability 0.32 0.36 0.32 A. B. C. D.

Outcome (Sales) $250,000 1,000,000 1,750,000

Probability 0.125 0.750 0.125

Outcome (Sales) $250,000 750,000 1,250,000

Assuming that the company has a 50 percent profit margin on sales, calculate the expected profits for each plan. Construct a simple bar graph of the possible profit outcomes for each plan. Which plan appears to be riskier? Calculate the standard deviation and coefficient of variation of the profit distribution associated with each plan. Assume that the management of Narcissism has a utility function like the one illustrated in the following figure. Which marketing strategy is best?

Relation Between Total U tility and Profit for NarcissismRecords, Inc.

U tility of Profits (Utils) 16 14 12 10 8 6 4 2 0 $0 $125 $250 $375 $500 $625 Total Profits ($000) $750 $875 $1,000 7.5 10 13 12 13.5
Total U tility

14

14.5

P16.5 A.

SOLUTION

Strategy 1: Consumer-Oriented Promotion Outcomes Expected

Probability (1) 0.32 0.36 0.32

(Sales) (2) $250,000 1,000,000 1,750,000

Profit (3) = (2) 0.5 $125,000 500,000 875,000

Profit (4) = (3) (1) $40,000 180,000 280,000 E(1) = $500,000

Strategy 2: Distributor-Oriented Promotion Outcomes Probability (1) 0.125 0.750 0.125 (Sales) (2) $250,000 750,000 1,250,000 Profit (3) = (2) 0.5 $125,000 375,000 625,000 Expected Profit (4) = (3) (1) $15,625 281,250 78,125 E(2) = $375,000

B.
Strate gy 1: Consume r Te le vis ion Promotion
P ro babil i ty (Pr)

0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0 $125 $250 $375 $500
To ta l Profit ($ 000)

$625

$750

$875

Strategy 2: Distributor Oriented Promotion

Probabil ity (Pr)

0.7

0.6

0.5

0.4 0.3

0.2

0.1 0.0 $125 $250 $375 $500

Total Profit ($000)

$625

$750

$875

Strategy 1 appears more risky than Strategy 2 due to the greater variability of outcomes.

C. Strategy 1 Probability (1) 0.32 0.36 0.32 Deviations (2) -$375,000 0 375,000 (Deviations) 2 (3) $1.406 1011 0 1.406 1011 Variance (4) = (1) (3) $4.5 1010 0 4.5 1010
2 1 = 9 1010

Standard deviation = 1 =

9 1010

= $300,000 Coefficien t of Variation = V = 1/E(R1) = 0.6 Strategy 2 Probability (1) 0.125 0.750 0.125 Deviations (2) -$250,000 0 250,000 (Deviations) 2 (3) $6.25 1010 0 6.25 1010 Variance (4) = (1) (3) $7.813 109 0 7.813 109
2 2 = 1.563 1010

Standard deviation = 2 = Coefficien t of Variation

1.563 1010 = $125,000

= V = 2/E(R2) = 0.33

A comparison of the standard deviations and coefficients of variation for each strategy confirms that Strategy 1 is the more risky promotional strategy.

D. Strategy 1 Expected Probability (1) 0.32 0.36 0.32 Profits (2) $125,000 500,000 875,000 Utils (3) 750 1,300 1,450 Utility (4) = (3) (1) 240 468 464 1,172 utils Strategy 2 Expected Probability (1) 0.125 0.750 0.125 Profits (2) $125,000 375,000 625,000 Utils (3) 750 1,200 1,350 Utility (4) = (3) (1) 93.75 900.00 168.75 1,162.50 utils The marketing manager should recommend Strategy 1 because of its slightly higher expected utility. In this instance, the higher expected profit of Strategy 1 more than offsets its greater risk. P16.6 Risk-Adjusted Discount Rates. One-Hour Dryclean, Inc., is replacing an obsolete dry cleaning machine with one of two innovative pieces of equipment. Alternative 1 requires a current investment outlay of $25,373, whereas alternative 2 requires an outlay of $24,199. The following cash flows (cost savings) will be generated each year over the new machines four-year lives: Probability Alternative 1 0.18 0.64 0.18 Alternative 2 0.125 0.75 0.125 Cash Flow $5,000 10,000 15,000 $8,000 10,000 12,000

A. B. C.

Calculate the expected cash flow for each investment alternative. Calculate the standard deviation of cash flows (risk) for each investment alternative. The firm will use a discount rate of 12 percent for the cash flows with a higher degree of dispersion and a 10 percent rate for the less risky cash flows. Calculate the expected net present value for each investment. Which alternative should be chosen?

P16.6 A.

SOLUTION Expected values of cash flows Probability (1) Alternative 1 0.18 0.64 0.18 Alternative 2 0.125 0.75 0.125 Cash Flow (2) $5,000 10,000 15,000 $8,000 10,000 12,000 (3) = (1) (2) $900 6,400 2,700 E(CF1) = $10,000 $1,000 7,500 1,500 E(CF2) = $10,000

B.

The relevant standard deviations of cash flows are: Probability (1) Alternative 1 0.18 0.64 0.18 Deviation (2) -$5,000 0 5,000 Deviation 2 (3) 2.5 107 0 2.5 10
7

(4) = (1) (3) $4,500,000 0 4,500,000

1 = $9,000,000 2

1 =

$9,000,000

= $3,000 Probability (1) Alternative 2 0.125 0.75 0.125 Deviation (2) -$2,000 0 2,000 Deviation 2 (3) 4 10 0 4 10
6 2 6

(4) = (1) (3) $500,000 0 500,000

2 = $1,000,000

2 = =

2
2

$1,000,000

= $1,000 Thus, alternative 2 is the less risky investment. C. Alternative 1 is riskier because it has the greater variability in its probable cash flows. This is obvious from an inspection of the distributions of possible returns and is verified by calculating the standard deviations. Hence, alternative 1 is evaluated at the 12 percent cost of capital, while alternative 2 requires a 10 percent cost of capital. $10,000 - $25,373 t t =1
4

NPV1

(1.12 )

= $10,000(PVIFA, n = 4, i = 12 percent) - $25,373 = $10,000(3.0373) - $25,373 = $5,000

NPV2

(1.10 )

$10,000 - $24,199 t t =1
4

= $10,000(PVIFA, n = 4, i = 10 percent) - $24,199 = $10,000(3.1699) - $24,199 = $7,500 The less risky Alternative 2 has the higher risk-adjusted net present value, and, therefore, is the more attractive investment. P16.7 Certainty Equivalents. Recently, the housing market suffered the worst slump in nearly two decades. Hot housing markets like Boston, Ft. Lauderdale Florida, and Washington DC cooled as rising interest rates and tightened lending standards eliminated lots of potential buyers. With job losses in the auto industry, the housing downturn was especially serious in Detroit and surrounding areas. Suppose a real estate speculator seeking to profit from the downturn bought a pool of home mortgages for $1 million on the expectation of quickly selling them to out-of-town investors for $1.5 million. If the deal falls through, the speculator would be able to just as quickly dump the pool of home mortgages in the secondary market for $800,000. A. B. Calculate the speculators expected payoff if there is a 50/50 chance of successfully selling the pool of home mortgages to out-of-town investors. Calculate the certainty equivalent adjustment factor for this investment. Is the speculators decision to buy the pool of home mortgages consistent with risk adverse behavior?

P16.7 .

SOLUTION If there is a 50/50 chance of successfully selling the bundle of home mortgages to outof-town investors, the speculators expected payoff is: E(R) = 0.5 $1,500,000 + 0.5 $800,000 = $1,150,000

B.

Yes, the real estate speculator is displaying risk-averse behavior. With an expected payoff of $1,150,000 and a required investment of $1 million, the certainty equivalent adjustment factor for this investment is at least = 0.87 because: = Certain Sum/Expected Risky Amount

= $1,000,000/$1,150,000 = 0.87 In making the purchase of the pool of home mortgages, the speculator is documenting that the pool with an expected value of $1,150,000 is worth at least $1million. This means that each dollar of risky expected return is worth at least 87 in certain dollars. If the speculator had been willing to pay more than $1 million, each expected risky dollar would have been worth more in terms of the amount of utility provided. Because the expected risky amount exceeds the amount invested, < 1 and the speculators decision to buy the pool of home mortgages is consistent with risk-averse behavior. P16.8 Certainty Equivalent Method. Tex-Mex, Inc., is a rapidly growing chain of Mexican food restaurants. The company has a limited amount of capital for expansion and must carefully weigh available alternatives. Currently, the company is considering opening restaurants in Santa Fe or Albuquerque, New Mexico. Projections for the two potential outlets are as follows: Annual Profit City Albuquerque Santa Fe Outcome Failure Success Failure Success Contribution $100,000 200,000 $60,000 340,000 Probability 0.5 0.5 0.5 0.5

Each restaurant would require a capital expenditure of $1.4 million, plus land acquisition costs of $1million for Albuquerque and $2 million for Santa Fe. The company uses the 5 percent yield on risk-free U.S. Treasury bills to calculate the risk-free annual opportunity cost of investment capital. A. B. C. Calculate the expected value, standard deviation, and coefficient of variation for each outlets profit contribution. Calculate the minimum certainty equivalent adjustment factor for each restaurants cash flows that would justify investment in each outlet. Assuming that the management of Tex-Mex is risk averse and uses the certainty equivalent method in decision making, which is the more attractive outlet? Why?

P16.8 A.

SOLUTION Albuquerque

E(A) = $100,000(0.5) + $200,000(0.5) = $150,000 A = ($100,000 - $150,000 )2 (0.5) + ($200,000 - $150,000 )2 (0.5) = $50,000 VA = A/E(A) = 0.33 Santa Fe E(SF) = $60,000(0.5) + $340,000(0.5) = $200,000 SF = ($60,000 - $200,000 )2 (0.5) + ($340,000 - $200,000 )2 (0.5) = $140,000 VSF = SF/E(SF) = 0.7 B. To justify each investment alternative, the company must have a certainty equivalent adjustment factor of at least = 0.8 for the Albuquerque project and = 0.85 for the Santa Fe project because: Certain Sum Expected Risky Sum Certain Cash Flow Foregone per year (Opportuni ty cost) Expected Profit contributi on per year (E( )) Albuquerque 0.05($2,400,000) $150,000

A =

= 0.8

Santa Fe SF = 0.05($3,400,000) $200,000

= 0.85 In words, each risky dollar of expected profit contribution from the Albuquerque outlet must be worth at least (valued as highly as) 80 in certain dollars to justify investment. For the Santa Fe outlet, each risky dollar must be worth at least 85 in certain dollars. C. Given managerial risk aversion, Albuquerque is the more attractive outlet because it has a lower risk, A < SF and VA < VSF, and is also less expensive in terms of the price of each risky dollar of expected profit contribution. A risk-averse management wouldnt pay 85 for each risky dollar of expected profit contribution from a Santa Fe outlet, when less risky expected returns from an Albuquerque outlet cost only 80. Decision Trees. Keystone Manufacturing, Inc., is analyzing a new bid to supply the company with electronic control systems. Alpha Corporation has been supplying the systems and Keystone is satisfied with its performance. However, a bid has just been received from Beta Controls, Ltd., a firm that is aggressively marketing its products. Beta has offered to supply systems for a price of $120,000. The price for the Alpha system is $160,000. In addition to an attractive price, Beta offers a money-back guarantee. That is, if Betas systems do not match Alphas quality, Keystone can reject and return them for a full refund. However, if it must reject the machines and return them to Beta, Keystone will suffer a delay costing the firm $60,000. A. Construct a decision tree for this problem and determine the maximum probability that Keystone could assign to rejection of the Beta system before it would reject that firms offer, assuming that it decides on the basis of minimizing expected costs. Assume that Keystone assigns a 50 percent probability of rejection to Beta Controls. Would Keystone be willing to pay $15,000 for an assurance bond that would pay $60,000 in the event that Beta Controls fails the quality check? (Use the same objective as in part A.) Explain.

P16.9

B.

P16.9 A.

SOLUTION The decision tree for this decision problem is as follows:

Pro ab b ili Acce t p 1 .0

Sys m t te Cos

$ 6 ,0 0 10 0

Pla ce

Acce t p

(1 a - )

$ 2 ,0 0 10 0

Re ct je

(a )

$ 0 ,0 0= 1 0 0 + 6 ,0 0 2 0 0 $ 6 ,0 0 $ 0 0

The maximum probability of rejection that could be assigned to the Beta control system is the probability that makes the expected cost equal for the two alternatives. Expected Beta Cost (1 - Pr)($120,000) + Pr($220,000) $120,000 - $120,000Pr + $220,000Pr $100,000Pr Pr = Alpha cost = $160,000 = $160,000 = $40,000 = 0.4 or 40 percent

If there is greater than 40 percent probability of Betas control system failing to pass the quality control inspection, then Keystone would choose to accept the bid from Alpha. B. Yes, to illustrate the advantage of an assurance bond, simply compare expected costs under each decision alternative. Without the assurance bond expected costs are: E(CA) = $160,000 E(CB)= 0.5($120,000) + 0.5($220,000) = $170,000.

Without the assurance bond, purchasing from Alpha has the lower expected cost. If the bond is purchased, only the expected cost of purchase from Beta changes. This expected cost would now be calculated as: E(CB) = $15,000 + 0.5($120,000) + 0.5($160,000) = $155,000. Thus, ordering the control from Beta with the assurance bond has the lower expected cost.

P16.10

Standard Normal Concept. Speedy Business Cards, Inc., supplies customized business cards to commercial and individual customers. The company is preparing a bid to supply cards to the Nationwide Realty Company, a large association of independent real estate agents. Because paper, ink, and other costs cannot be determined precisely, Speedy anticipates that costs will be normally distributed around a mean of $20 per unit (each 500-card order) with a standard deviation of $2 per unit. A. B. C. What is the probability that Speedy will make a profit at a price of $20 per unit? Calculate the unit price necessary to give Speedy a 95 percent chance of making a profit on the order. If Speedy submits a successful bid of $23 per unit, what is the probability that it will make a profit?

P16.10 A.

SOLUTION If printing costs are normally distributed around a mean of $20 per unit, there is a 50/50 or 50 percent chance that actual costs will be above or below that amount. This means that there is a 50/50 or 50 percent chance that revenues will exceed costs and, therefore, that Speedy will make a profit at a price of $20. In order to have a 95 percent chance of making a profit, 95 percent of the area under the normal curve describing the distribution of costs per unit must lie to the left of price. Using the standardized normal formula, this occurs at a z value of 1.645. This implies a price of $23.29 because:

B.

Probability (Pr) 0.5

A Normal Distribution of Unit Costs for Speedy Business Cards, Inc.

0.4

0.3

The probability of making a profit at a price of $23.29 is 95% because 95% of the area under the normal curve is to the left of P = $23.29

0.2

0.1

0.0 E(Cost) = $20

P = $23.29

x- P - $20 $2

1.645 $3.29 P

= P - $20 = $23.29

C.

With a price of $23, Speedys winning bid is 1.5(= $3/$2) standard deviations higher than expected costs. From the normal distribution, there is a 0.5 + 0.4332 = 93.32 percent probability that Speedy will be able to make a profit at a price of $23 per unit.

CASE STUDY FOR CHAPTER 16 Stock-Price Beta Estimation for Google, Inc. Statisticians use the Greek letter beta to signify the slope coefficient in a linear relation. Financial economists use this same Greek letter to signify stock-price risk because betas are the slope coefficients in a simple linear relation that links the return on an individual stock to the return on the overall market in the capital asset pricing model (CAPM). In the CAPM, the security characteristic line shows the simple linear relation between the return on individual securities and the overall market at every point in time: Rit = i + i R Mt + i , where Rit is the rate of return on an individual security i during period t, the intercept term is described by the Greek letter (alpha), the slope coefficient is the Greek letter (beta) and signifies systematic risk (as before), and the random disturbance or error term is depicted by the Greek letter (epsilon). At any point in time, the random disturbance term has an expected value of zero, and the expected return on an individual stock is determined by and . The slope coefficient shows the anticipated effect on an individual securitys rate of return following a 1 percent change in the market index. If = 1.5, then a 1 percent rise in the market would lead to a 1.5 percent hike in the stock price, a 2 percent boost in the market would lead to a 3 percent jump in the stock price, and so on. If = 0, then the rate of return on an individual stock is totally unrelated to the overall market. The intercept term shows the anticipated rate of return when either = 0 or RM = 0. When > 0, investors enjoy positive abnormal returns. When < 0, investors suffer negative abnormal returns. Investors would celebrate a mutual fund manager whose portfolio consistently generated positive abnormal returns ( > 0). They would fire portfolio managers that consistently suffered negative abnormal returns ( < 0). In a perfectly efficient capital market, the CAPM asserts that investor rates of return would be solely determined by systematic risk and both alpha and epsilon would equal zero, = = 0. Figure 16.8 here As shown in Figure 16.8, managers and investors can estimate beta for individual stocks by using a simple ordinary least-squares regression model. In this simple regression model, the dependent Y-variable is the rate of return on an individual stock, and the independent X-variable is the rate of return on an appropriate market index. Within this context, changes in the stock market rate of return are said to cause changes in the rate of return on an individual stock. In this example, beta is estimated for Google, Inc., (ticker symbol: GOOG), the Mountain View, California provider of free Internet search and targeted advertising services. The price data used to estimate beta for GOOG were downloaded from the Internet at the Yahoo! Finance Web site (http://finance.yahoo.com). Weekly returns for GOOG and for the Nasdaq stock market were analyzed over the 52-week trading period ending on May 29, 2007, as shown in Table 16.6. In this case, as predicted by the CAPM, = 0.0026 (t = 0.70). For a typical week when the Nasdaq market return was zero (essentially flat) during this initial 52-week trading period, the return for GOOG common stockholders was 0.26 percent. Because < 1, GOOG was less volatile than the Nasdaq market during this period. During a week when the Nasdaq market rose by 1 percent, GOOG rose by 0.9588 percent; during a week when the Nasdaq market fell by 1 percent, GOOG fell by 0. 9588 percent. The slope coefficient = 0.9588 is statistically

significant (t = 5.32). This means that returns on GOOG stock had a statistically significant relationship to returns for the Nasdaq market during this period. In the case of GOOG, the usefulness of beta as risk measures is undermined by the fact that the simple linear model used to estimate stock-price beta fails to include other important systematic influences on stock market volatility. In the case of GOOG, for example, R2 information shown in Figure 16.8 indicates that only 36.1 percent of the total variation in GOOG returns can be explained by variation in the Nasdaq market. This means that 63.9 percent of the variation in weekly returns for GOOG stock is unexplained by such a simple regression model. . . Describe some of the attributes of an ideal risk indicator for stock market investors. On the Internet, go to Yahoo! Finance (or msnMoney) and download weekly price information over the past year (52 observations) for GOOG and the Nasdaq market. Then, enter this information in a spreadsheet like Table 16.6 and use these data to estimate GOOG=s beta. Describe any similarities or dissimilarities between your estimation results and the results depicted in Figure 16.8. Estimates of stock-price beta are known to vary according to the time frame analyzed; length of the daily, weekly, monthly, or annual return period; choice of market index; bull or bear market environment; and other nonmarket risk factors. Explain how such influence can undermine the usefulness of beta as a risk indicator. Suggest practical solutions.

CASE STUDY SOLUTION A. An ideal measure of stock market risk would be simple to derive, accurate and consistent from one year to another. With an ideal risk measure, investors are able to control the risk exposure faced during volatile markets with well-targeted and welltimed investment buy/sell decisions. For example, suppose an elderly investor wants to maintain an exposure to the equity markets during retirement, but wants to limit risk to regulate the possibility of devastating losses. With an ideal risk measure, retired investors could precisely tilt portfolio allocation toward securities with low risk characteristics. Alternatively, if an investor anticipated a surge in stock prices following a decline in interest rates, precise risk measures could help such an investor tilt an investment portfolio toward more volatile stocks. The usefulness of stock market risk indicators diminishes to the extent that they fail to provide accurate and consistent measures of risk exposure from one year to another. In fact, an important limitation of risk estimators derived from the CAPM is that they vary from one period to another in ways that prove highly unpredictable. When betas vary from one year to another in ways that are essentially random and unpredictable, betas fail to provide investors with a risk assessment tool that can be used to effectively manage portfolio risk. It will be a real eye-opener to students when they estimate stock-price beta for GOOG over a more recent time period using weekly returns and compare those results with the beta estimate derived from the monthly returns reported in Table 16.6 for the 52week time period shown in Figure 16.8. Stock-price beta estimates often vary

B.

markedly depending upon the time frame analyzed, and according to the daily, weekly, monthly, or annual return interval examined. Such differences, if severe, can undermine the credibility of stock-price betas as useful risk indicators. C. Empirical estimates of stock-price beta are known to vary according to the time frame analyzed; length of the daily, weekly, monthly, or annual return period; choice of market index; bull or bear market environment; and other nonmarket risk factors. For example, estimates of beta tend to be imperfect risk measures because return volatility for the overall market is very difficult to measure. On the nightly news, when commentators talk about the market being up or down, they often refer to moves in the DJIA. Whereas the DJIA offers good insight concerning changes in the prices of large blue chip companies, it offers little insight concerning volatility in the returns earned by investors in smaller high-tech stocks. From the perspective of many individual and institutional investors, the S&P 500 Index gives superior insight concerning moves in the overall market, but like the DJIA, the S&P 500 is dominated by large blue chip companies. Although the Nasdaq and Russell 2000 indexes are popular measures of high-tech and smaller stocks, they are much less informative about changes in the overall market. While there is a high degree of correlation in rates of return earned on the DJIA, S&P 500, Nasdaq, and Russell 2000 indexes, slight differences can have big effects on beta estimates. From a theoretical perspective, the most appropriate benchmark would be a market index that included all capital assets, including stocks, bonds, real estate, collectibles, and so on. Unfortunately, no such market index is available. To greater or lesser degree, this affects the accuracy of all beta estimates and undermines confidence in beta as an accurate measure of security risk. Another important problem faced in obtaining consistent and reliable beta estimates is the fact that beta estimates are sensitive to the length of time over which stock return data are measured. When beta estimates differ according to daily, weekly, monthly or annual returns, the usefulness of stock-price beta as a consistent measure of risk is greatly diminished. The presence of market index bias and return interval bias, among other problems, makes it imperative that beta comparisons among individual companies reflect identical estimation periods, return intervals, and appropriate market benchmarks.