PRESENTATION TO FIN 6000 CLASS -SUMMER 2012

INSTRUCTOR: Prof. F.M. Gatumo

2012 F.M. Gatumo FIN 6000 Summer 2012

PERSONAL BANKING PRODUCTS PRESENTATION FOCUS

CAPITAL BUDGETING

2012 F.M. Gatumo FIN 6000 Summer 2012

CAPITAL BUDGETING TECHNIQUES UNDER RISK

At the end of this chapter, the student should be able to: define business risks Classify the various types of risks inherent in a business Compute the expected returns of a business in percentages and absolute terms( E(Ra) Compute the risk of a business using the standard deviation as a measure( a) Compute the coefficient of variation
2012 F.M. Gatumo FIN 6000-Summer 2012

PREAMBLE
An investment is an outlay of massive amount of funds with expectation of cash inflows that exceed the cash outflows. The event sacrifices current consumption with the hope of improving future consumption. Investments are expected to address the constraints that an organization faces in the market place. Investments must be undertaken to ensure that the existing organizational strengths are reinforced, weaknesses are minimized through increased investment, investments are made towards the organizations opportunities and that investments must be made to shield the organization from perceived threats

2012 F.M. Gatumo FIN 6000 Summer 2012

strengths

weaknesses

opportunities threats

Invest (growth companies, large market share, competitive advantages

Invest to minimize weaknesses through theory on constraints (COT)

Invest(targete Invest (shield d investment) and hedge and overcome) OR DIVEST

2012 F.M. Gatumo FIN 6000 Summer 2012

In line with the Boston Consulting Group (BCG), a company will invest in the STARS, STAGS and DIVEST in the DOGS and MILK DRY in the CASH COWS
Market Share

H
H
Growth L
Stars Stags

Cash Cows

Dogs

2012 F.M. Gatumo FIN 6000 Summer 2011

 Asnoff diversification model does offer us a logical

pattern of a

companys growth
New markets Old markets

New products

Diversification

Product diversification

Old products

Old products

Penetration

2012 F.M. Gatumo FIN 6000 Summer 2012

In the above model, investments will be in the diversification where investment will be in new products (new plant and machinery) and investment in developing new lines of distribution. In the case of the market diversification and the product diversification the organization must invest into new product plant and machinery or retool the existing machinery and or develop new markets by creating new lines of distribution Investments are undertaken in the midst of numerous risks These risks are business risk, financial risk, default risk, cash flow risk, credit risk, inflation risk, interest rate risk and exchange rate risk, to name but a few.

2012 F.M. Gatumu FIN 6000 Summer 2012

These risks are caused by changes in the market place that impact the projected cash inflows of a business or organization. These changes are caused by: market changes- changes in the customer consumption pattern, lifestyles, fashion changes competition many manufacturers and suppliers of substitutes at very attractive prices and diversified products changing macroeconomic variables that cause the markets risks( systematic risks) and the extent to which the public sector build public governance structures changes in the organization( governance structures) and its microeconomic variables
2012 F.M. Gatumo FIN 6000 Summer 2012

1 Presumption of Risk
All investments presume some degree of risk. The types of risk are twofold: Systematic. These are risks that are externally driven. They are caused by misalignment of macroeconomic variables. The macroeconomic variables referred to are: Interest rates, inflation rates, exchange rates, fiscal and monetary policies, the balance of trade and balance of payments, the GDP, the savings and investment levels, the social capital formation and the politics. These risks are addressed through good Public governance

2012 F.M. Gatumo FIN 6000 Summer 2012

Presumption of Risk Cont Unsystematic; these are a series of risks that are caused by poor corporate governance. It results from failure of a company to address key aspects of its existence. Lack of shared values, structures, systems, and leadership and communication systems will cause a company to embrace very large spreads in its predicted cash flows and its attained cash flows. A corporation can minimize the unsystematic risks by proactively creating and nurturing good corporate governance structures. The normal curve aids in demonstrating the concept of risk or spread or volatility
2012 F.M. Gatumo FIN 6000 Summer 2012

+-1---------68% +-2---------95% +-3---------99%

2012 F.M. Gatumo FIN 6000 Summer 2012

Previously, we explored on how investments can create wealth through the capital budgeting techniques under certainty. The key variables were: i)Outflows were certain ii)Projected cash inflows were certain iii)The cost of money was known The study of capital budgeting techniques under risk reveals to us how nave the assumptions were. The chances of wealth creation become then just a myth. The study of capital budgeting techniques under risk demystifies the assumptions under the previous study.
2012 F.M. Gatumo FIN 6000 Summer 2012

The study provides a series of parameters that investors must compute and apply in arriving at optimal investment decisions. The parameters to be computed are:

Expected returns ( pi Ri) Total risk = square root ( pi)( Ri-E(Ri)2 Coefficient of variation / E(Ri) Covariance A and B( COV AB) Rho (AB)
2012 F.M. Gatumo FIN 6000 Summer 2012

 Beta( A) = Market risk E(Rp)= wiE(Ri) 2 2 2 2 PAB= square root x + (1-x) +2x(1x)x(1-x) where x refers to investment A while 1x refer to investment B Coefficient of variation of portfolio

2012 F.M. Gatumo FIN 6000 Summer 2012

3. A successful investment is undertaken under interdisciplinary team that examines all aspects of the investment so as to assure success of the investments. The staticians and the marketers will examine the potential states of the world and ascertain the possible probabilities of occurrence of net cash flows and the possible % returns.. The process is eclectic in nature. This is the process used by the actuarial scientists to arrive at the states of the world and the occurrences of an event.
2012 F.M. Gatumo FIN 6000 Summer 2012

The use of the capital budgeting techniques under risk provides the investor a broader view of investments and enables the investor to hedge against potential risks whether they are systematic or unsystematic. The investor, through the use of capital budgeting techniques under risk is able to classify risks into: Systematic Unsystematic risks
2012 F.M. Gatumo FIN 6000 Summer 2012

The unsystematic risk can be diversified away through diversification of investments. The investor require to monitor the Rho(P).If an investor has up to 15 investments, it can be shown that the unsystematic risks will be zero. The total variance of an investment is established from 2 ARrm2+ E2 The last component comprise of the error term .William Sharpe has shown that when a security is properly diversified, the error term is zero. It is important for the investor to compute the parameters that will provide him/her with the discounting rates. These rates must be the same as the expected returns of the investments. These are measures of marginal returns.
2012 F.M. Gatumo FIN 6000 Summer 2012

Example 1.

Suppose investment in A promises a return of 10%, and probability is 40%, while second promise of 20% has a probability of 60%. Establish the various investment parameters.

Pi 0.4 0.6 E(RA)

Ri 0.1 0.2

Pi*Ri 0.04 0.12 0.16

2012 F.M. Gatumo FIN 6000 Summer 2012

Example 2.

Suppose Alex invests in project B. Suppose also Alex is 30% sure of obtaining net cash flows of ksh 1,000 and is 70% sure of receiving net cash flows of ksh 500. Compute his expected returns in absolute terms
Pi 0.3 0.7 Rb 1000 500 Expected return KES Pi*Rb 300 350 650

Note the investor has only one parameter to assist him/her make the investment decision.

2012 F.M. Gatumo FIN 6000 Summer 2012

Example 1
Using the above examples we can compute the relevant risk of the in vestments.
Pi Ri E(Ri) Ri-E(Ri) (Ri-E(Ri))2 Pi(Ri-e(Ri))2

0.4 0.6 Variance Risk A

0.1 0.2

0.16 0.16

0.06 0.04

0.0036 0.0016

0.00144 0.00096 0.00240 0.049 4.9%

2012 F.M. Gatumo FIN 6000 Summer 2012

Example 2

Pi

Rb

E(Rb)

Rb-E(Rb)

( Rb-E(Rb))2

Pi(Rb-E(Rb))2

0.3

1000

650

350

122500

36750

0.7

500

650

-150

22500

15750

Variance of B

52500

Risk of B

229

2012 F.M. Gatumo FIN 6000 Summer 2012

Example 3
Coefficient of variation A B 4.9/0.16=0.31 229/650=0.35

Investments are selected on the basis of coefficient of variation. The less the better for an investment. The use of the risk can be assessed from the statistical measurement variables as shown below.
2012 F.M. Gatumo FIN 6000 Summer 2012

 NORMAL DISTRIBUTION IN AN INVESTMENT VALUE AT RISK- VAR OF AN INVESTMENT Z (90%) -------1.645 Z (95%) -------1.960

Z (98%) ------ 2.330

Z (99%) -------2.576

2012 F.M. Gatumo FIN 6000 Summer 2012

END
THANK YOU!!

2012 F.M. Gatumo FIN 6000 Summer 2012