RISK AND RETURNS

ACC09 FINANCIAL MANAGEMENT

PART 2

The Risk Management

Function
Managing firms exposures to all
types of risk in order to maintain
optimum risk-return trade-offs and
thereby maximize shareholder
value.
Modern risk management focuses
on adverse interest rate
movements, commodity price
changes, and currency value
fluctuations.
2

2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly
accessible Web site, in whole or in part.

EFFECT OF MARKET
DIVERSIFICATION TO FIRM-SPECIFIC
AND MARKET RISKS

Risk-Return Trade-of

2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
Web site, in whole or in part.

TWO BASIC RULES IN BASIC

RISK MANAGEMENT
REQUIRE RETURNS AT LEAST
EQUAL TO THE RISK ONE IS
WILLING TO TAKE.
TO MEASURE RISK IS TO
MEASURE RETURN

EXPECTED VALUE OF
RETURNS
describes the numerical
average of a probability
distribution of estimated
future cash receipts from an
investment project

EXPECTED VALUE OF
RETURNS
Estimating the various amounts of cash

receipts from the project each year under

different assumptions or operating con
ditions
Assigning probabilities to the various
amounts estimated for one year, and
Determining the mean value. The expected
present value of all, future receipts could
then be determined by summing the
expected discounted value of all years.

EXPECTED VALUE OF
RETURNS

The GREATER the Expected

Value or Pay-off, the BETTER.

MEASUREMENTS OF RISK

Variance
Standard Deviation (SD)
Coefficient of Variation (CV)
Beta
Covariance

The Variability of Stock

Returns

Normal distribution can be described by its

mean and its variance.

Variance ( 2) a measure of volatility in

units of percent squared
N

Variance
2

(k
t 1

k)

N 1

FOR
UNGROUPED
DATA

Standard deviation a measure of volatility in

percentage terms

Standard deviation Variance

2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly
accessible Web site, in whole or in part.

The Variability of Stock

Returns

Normal distribution can be described by its

mean and its variance.

Variance ( 2) a measure of volatility in

units of percent squared
N

Variance 2

( (kt k ) 2 Pt )
t 1

FOR
GROUPED
DATA

Standard deviation a measure of volatility in

percentage terms

Standard deviation Variance

2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly
accessible Web site, in whole or in part.

EXERCISE 1
The following table summarizes
the annual returns you would
have made on two companies:
One, a satellite and data
equipment manufacturer, and
Two, the telecommunications
giant, from 200A to 200J.

EXERCISE 1

TW

ONE
Year
O Year
200 80.9 58.2 200
A
5
6 E
200
- 200
B
47.3 33.7 F
7
9
200 31.0 29.8 200
C
0
8 G
200
D

TW

TW
ONE
ONE
O Year
O
32.0 2.94 200I 11.6 48.6
2
7
4
25.3 -4.29 200J 36.1 23.5
7
9
5

- 28.8

28.5
6
Estimate the EXPECTED
RETURN,
7
132.
30.3 200
-

VARIANCE,
and0.00
STANDARD
4
5 H in annual6.36
DEVIATION
returns in each

company

Portfolio EV, Variance,

and
SD
The expected return is equal to the
WEIGHTED AVERAGE returns of the assets
in the portfolio.
The variance of a 2-asset portfolio is equal
to
=wi2 (i) 2 + w22 (2) 2 + 2 (wi)(i) (w2)(2) (r2)
=wi2 (i) 2 + w22 (2) 2 + 2 (wi) (w2)(Cov)
The SD is equal to the square root of the
variance of the portfolio.

The Relationship Between Portfolio

Standard Deviation and the Number
of Stocks in the Portfolio
Market rewards only
systematic risk.

What really matters is systematic

risk.
how a group of assets move together.

The
that diversification
eliminates
is called
Therisk
trade-off
between S.D.
and average
returns
unsystematic risk; The risk that remains, even in a
that holds for asset classes does not hold for
diversified portfolio, is called systematic risk.

individual stocks!

2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly
accessible Web site, in whole or in part.

The Variability of Stock

Returns
Coefficient of Variation (CV) a
better measure of total risk than the
standard deviation, especially when
comparing investments with different
expected returns
CV = Standard Deviation = Standard Deviation

Mean Return
Expected Return

The Variability of Stock

Returns
Covariance (Cov) a measure of
the general movement relationship
between two variables. It is usually
measured in terms of correlation
coefficient and asset allocation
Recall:
The variance of a 2-asset portfolio is equal to
=wi2 (i) 2 + w22 (2) 2 + 2 (wi)(i) (w2)(2) (r2)
=wi2 (i) 2 + w22 (2) 2 + 2 (wi) (w2)(Cov)
(Cov)
How would one compute for Cov?

EXERCISE 2
The following table summarizes
the annual returns you would
have made on two companies:
One, a satellite and data
equipment manufacturer, and
Two, the telecommunications
giant, from 200A to 200J.

EXERCISE 2

TW

ONE
Year
O Year
200 80.9 58.2 200
A
5
6 E
200
- 200
B
47.3 33.7 F
7
9
200 31.0 29.8 200
C
0
8 G
200
D

TW

TW
ONE
ONE
O Year
O
32.0 2.94 200I 11.6 48.6
2
7
4
25.3 -4.29 200J 36.1 23.5
7
9
5

- 28.8

28.5
6
If the correlation of7 these two
132.
30.3 200is 0.54069,
0.00
-
investments
estimate
the
4
5 of
H a portfolio6.36
variance
composed, in

equal parts, of the two investments.

ILLUSTRATIVE PROBLEM 1
Demand for
the
company's
products

Strong
Normal
Weak

Probability of
this
demand
occurring

0.30
0.40
0.30
1.00

Rate of Return on stock

if this demand occurs
Company 1 Company 2
100%
20%
15%
15%
-70%
10%

1. Expected or Average Stock Return

2. Variance of Stock returns of each
3. Standard Deviation of Stock returns
of each

ILLUSTRATIVE PROBLEM 2
Demand for
the
company's
products

Strong
Normal
Weak

4.
5.
6.

Probability of
this
demand
occurring

0.30
0.40
0.30
1.00

Rate of Return on stock

if this demand occurs
Company 1 Company 2
100%
20%
15%
15%
-70%
10%

Coefficient of Variation of each

Covariance
Assuming that you are to invest 30% of your
investment funds in Company 1 and 70% in
Company 2, and their Correlation is 0.351
compute for the: (A)Variance of 2-Asset Portfolio
(B) Standard Deviation of the 2-Asset Portfolio

The Variability of Stock

Returns
Beta Estimate ()
( of an individual
stock is the correlation between the
volatility (price variation) of the
stock market and the volatility of
the price of the individual stock.
The beta is the measure of the
undiversifiable, systematic market
risk.

SML: ki = kRF + (kM kRF) i

The SML commonly adopts the CAPM model

The Variability of Stock

Returns
If = 1.0, then the Asset is an
average asset.
If > 1.0, then the Asset is riskier
than average.
If < 1.0, then the Asset is less risky
than average.
Can beta be negative?

Most stocks have betas in the range of 0.5 to 1.5

The Variability of Stock

Returns
The Hamada equation below is
used to compute for new beta shall
there be changes in capital structure.
Current, levered
.
u=

[1 + {(1-tax rate)(Debt/Equity)}]

Most stocks have betas in the range of 0.5 to 1.5

ILLUSTRATIVE PROBLEM 2
In December 200B, AAAs stock had a
beta of 0.95. The Treasury bill rate at
that time was 5.8%. The firm had a
debt outstanding of P1.7B and a
market value of equity of P1.5B; the
corporate marginal tax rate was 36%.
The registered risk premium at
December 200B is 8.5%.

Most stocks have betas in the range of 0.5 to 1.5

ILLUSTRATIVE PROBLEM 2

In December 200B, AAAs stock had a beta of 0.95. The

Treasury bill rate at that time was 5.8%. The firm had a
debt outstanding of P1.7B and a market value of equity of
P1.5B; the corporate marginal tax rate was 36%. The
registered risk premium at December 200B is 8.5%.

Estimate the expected return on the

stock.
Assume that a decrease in risk-free rate
occurs and is attributed to an
improvement in inflation rates, but that
by January of 200C, the inflation rate
deteriorates or increases by 1.25%,
compute for the required rate of return
of a marginal investor.

ILLUSTRATIVE PROBLEM 2

In December 200B, AAAs stock had a beta of 0.95. The

Treasury bill rate at that time was 5.8%. The firm had a
debt outstanding of P1.7B and a market value of equity of
P1.5B; the corporate marginal tax rate was 36%. The
registered risk premium at December 200B is 8.5%.

Assume that marginal investors become

more risk-averse and thus require a
change in the risk premium by 4%, what
will be the effect on their required rate of
return?
The current beta is 0.95. This is assumed
to be a levered beta since this has been
registered even if there is outstanding
debt of P1.7B. Compute for unlevered

ILLUSTRATIVE PROBLEM 2

In December 200B, AAAs stock had a beta of 0.95. The

Treasury bill rate at that time was 5.8%. The firm had a
debt outstanding of P1.7B and a market value of equity of
P1.5B; the corporate marginal tax rate was 36%. The
registered risk premium at December 200B is 8.5%.

How much of the risk measured by beta

in g above can be attributed to (1)
business risk, and (2) financial leverage
risk?

ILLUSTRATIVE PROBLEM 3
Assume that the treasury bill rate is 8%
and the market risk premium is equal to
7%.
Securities
A
B
C
D
E

Expected
Returns
17.4%
13.8
1.7
8.0
15.0

Beta
1.29
0.68
-0.86
0.00
1.00

1.Use SML to calculate the required

returns

ILLUSTRATIVE PROBLEM 3
2. Compare the required returns and the
expected returns, determine which
securities are to be bought.
Securities
A
B
C
D
E

Expected
Returns
17.4%
13.8
1.7
8.0
15.0

Beta
1.29
0.68
-0.86
0.00
1.00

3. Calculate beta for a portfolio with

50% A Securities and C Securities
4. How much will be the required
return on the A/C portfolio in

ILLUSTRATIVE PROBLEM 4
PG which owns and operates grocery
stores across the Philippines, currently
has P50 million in debt and P100M in
equity outstanding. Its stock has a
beta of 1.2. It is planning a leveraged
buyout (LBO) , where it will increase
its debt/equity ratio of 8. If the tax
rate is 40%, what will the beta of the
equity in the firm be after the
LBO?

HOMEWORK 1
Zuni-GAS is a regulated
utility serving Northern
Luzon. The following table
lists the stock prices and
dividends on U Corp from
200A to 200J.

HOMEWORK 1
Compute for the expected return
Year Pric Divi Year Pric Divi Year Pric Divi
e
den
e
den
e
den
ds
ds
ds
200 36.1 3.00 200 26.8 1.60 200I 24.2 1.60
A
0
E
0
5
200 33.6 3.00 200 24.8 1.60 200J 35.6 1.60
Estimate
B
0 the average
F
0 annual return0 you
would
have3.00
made
on your
200 37.8
200
31.6 investment
1.60
Estimate
C
0 the standard
G
0 deviation and vari
200 30.9
2.30 returns.
200 28.5 1.60

ance
in annual
D
0
H
0

HOMEWORK 2

Assume you have all your wealth (P1

million) invested in the PSE index fund, and
you expect to earn an annual return of 12
percent with a standard deviation in returns
of 25 percent. Because you have become
more risk averse, you decide to shift
P200,000 from the PSEi fund to Treasury
bills. The T bill rate is 5%. Estimate the
expected return and standard
deviation of your new portfolio

HOMEWORK 3A
Novell which had a market value of equity of P2
billion and a beta of 1.50, announced that it
was acquiring WordPerfect, which had a market
value of equity of P 1 billion, and a beta of
1.30. Neither firm had any debt in its financial
structure at the time of the acquisition, and the
corporate tax rate was 40%.
Estimate the beta for Novell after the
acquisition, assuming that the entire
acquisition was financed with equity.

HOMEWORK 3B
Novell which had a market value of equity of P2
billion and a beta of 1.50, announced that it was
acquiring WordPerfect, which had a market value
of equity of P 1 billion, and a beta of 1.30.
Neither firm had any debt in its financial
structure at the time of the acquisition, and the
corporate tax rate was 40%.

Assume that Novell had to

borrow the P 1 billion to acquire
WordPerfect, estimate the
beta after the acquisition