1. 11 Making Informed Judgments Part 4 Risks and Rewards Navigating Accounting, ® G. Peter & Carolyn R. Wilson, © 1991-2009 NavAcc LLC. Modified by [Your Name].

2. 22Menu  Asset uncertainty and measurement dispersion Asset uncertainty and measurement dispersion  Asset risk Asset risk  Risks and rewards Risks and rewards  Risks and returns Risks and returns  Financial leverage and its consequences Financial leverage and its consequences  Closing thoughts Closing thoughts View in Slide Show Mode > click hyperlink.

3. 33 Asset Uncertainty and Measurement Dispersion  Asset uncertainty  Existence of more than one possible realization of the future benefits associated with an asset. Things You Need to Know  Computer example:  You purchase a computer for $1,400 expecting that using it for its three-year expected life will help you increase your human capital’s value by $1,500.  At the time of the purchase, you believe a $1,500 increase in the value of your human capital is the most likely outcome; but it is possible that the benefits you actually realize could fall anywhere between $1,000 and $2,000 if the computer provides less or more benefits than expected. Return to menu

4. 44 Asset Uncertainty and Measurement Dispersion  Measuring asset uncertainty  Assigning probabilities to possible future benefit realizations. 1 Things You Need to Know 1. Definitions presented here for asset uncertainty, measuring asset uncertainty, asset risk, and measuring asset risk are based on more general definitions in Wikipedia. “Risk." Wikipedia: The Free Encyclopedia. 3 April 2009. Wikipedia attributes Douglas Hubbard "How to Measure Anything: Finding the Value of Intangibles in Business" pg. 46, John Wiley & Sons, 2007 and Douglas Hubbard "The Failure of Risk Management: Why It's Broken and How to Fix It, John Wiley & Sons, 2009. Return to menu

5. 55 Asset Uncertainty and Measurement Dispersion  Continuation of computer example…  You believe the possible realized values of the computer’s future benefits could fall anywhere between $1,000 and $2,000 with the probabilities indicated below: Things You Need to Know Return to menu

6. 66 Asset Uncertainty and Measurement Dispersion  Uncertainty associated with an asset depends on:  The range of possible realized future benefits  The pattern of probabilities assigned to them  You would be more uncertain about your computer purchase if the possible future benefits and probabilities followed the pattern on the right below: Things You Need to Know Return to menu

7. 77 Asset Uncertainty and Measurement Dispersion Answer the following question from the perspective of a representative student in your group:  How does uncertainty associated with the value of your assets compare to the dispersion of objective experts’ estimates of these values? Questions Return to menu

8. 88 Asset Uncertainty and Measurement Dispersion  The dispersion of objective experts’ estimates of an asset’s value reflects their collective uncertainty about possible future realizations and specifies the:  Range of possible realized future benefits and  Pattern of probabilities, where the probabilities depend on the percentage of experts predicting related realizations. Take Aways Return to menu

9. 99 Asset Uncertainty and Measurement Dispersion  Information is useful for prediction when it:  Helps measure uncertainty:  Helps specify a range of possible outcomes  Helps specify related probabilities  Reduces uncertainty:  Narrows the range of possible outcomes  Narrows the dispersion of the probability distribution Take Aways Return to menu

10. 10 Asset Risk  Asset risk  Asset uncertainty where some of the possible future benefit realizations result in losses, meaning the realized values of the future benefits are less than the asset’s current value. 1 Things You Need to Know  Measuring asset risk  Quantifying the probabilities and losses associated with asset uncertainty. 1 Return to menu 1. Definitions presented here for asset uncertainty, measuring asset uncertainty, asset risk, and measuring asset risk are based on more general definitions in Wikipedia. “Risk." Wikipedia: The Free Encyclopedia. 3 April 2009. Wikipedia attributes Douglas Hubbard "How to Measure Anything: Finding the Value of Intangibles in Business" pg. 46, John Wiley & Sons, 2007 and Douglas Hubbard "The Failure of Risk Management: Why It's Broken and How to Fix It, John Wiley & Sons, 2009.

11. 11 Asset Risk  An asset has a possible loss when a possible realized value of its future benefits is less than its current value.  On the date you buy the computer, the current value is the purchase price. Things You Need to Know Return to menu

12. 12 Asset Risk  The possible loss realizations are to the left of the current value—values below $1,400. Things You Need to Know Return to menu

13. 13 Asset Risk  To measure the risk associated with the purchase, you need to estimate: the possible loss realizations and the related loss probabilities. The shaded region below represents this risk. Things You Need to Know Return to menu

14. 14 Asset Risk  Suppose the figure on the left below represents everybody else’s beliefs about the future benefits they expect to get from the computer and the one on the right represents your beliefs about the expected benefits.  Should you expect to pay less than $1,400, more than $1,400, exactly $1,400 for the computer? Questions Everyone Else Your Expectations Return to menu

15. 15 Asset Risk  The computer manufacturer just released a report that lead you and everyone else to conclude the possible realizations and probabilities on the right below are now more representative.  Should you now expect to pay less than $1,400, more than $1,400, exactly $1,400 for the computer? Questions You and Everyone Else Return to menu

16. 16 Asset Risk  The same asset purchased for the same price can have different risks for different owners either because: they plan to use the asset differently or they otherwise have different beliefs about its future usefulness. Take Aways Return to menu

17. 17 Asset Risk  Generally, when buyers believe an asset will be less risky than previously thought, its price will increase, reflecting buyers’ willingness to pay more for less risk. Take Aways Return to menu

18. 18 Asset Risk  Generally, when buyers believe an asset will be more risky than previously thought, its price will decrease. Take Aways  This will not be true when buyers can diversify the additional risk with other assets or liabilities, are risk seekers, or are not behaving rationally. Return to menu

19. 19 Asset Risk Caveat: Watch for different terminology Return to menu

20. 20  Compare the risks of Intel’s cash & cash equivalents and inventories. What are the sources of these risks? Question Asset Risk Return to menu

21. 21 Asset Risk  Asset risk varies considerably across assets. This creates demand for disclosure of asset line items on balance sheets.  Insiders’ and outsiders’ risk assessments are more informed to the extent they understand the business context:  Can identify things that can go wrong  Can secure and analyze information to estimate the likelihoods these things will occur and their related consequences Take Aways Return to menu

22. 22 Asset Risk  Uncertainty is necessary for measurement to be challenging.  Insiders and outsiders need to understand related uncertainties and risks to prepare and evaluate the usefulness of reported measures. Take Aways Return to menu

23. 23 Risks and Rewards  Risk and reward are the downside and upside of uncertainty, respectively. What You Should Know Return to menu

24. 24 Risks and Rewards  The larger the risk, the bigger the expected reward:  Assuming the risk can’t be diversified, the asset holders are not risk seekers, and everyone is behaving rationally.  Generally, if enough buyers perceive risk has increased, prices will decrease to compensate buyers for assuming the increased risk. What You Should Know Return to menu

25. 25 Risks and Returns  To allow investors to compare investment opportunities for assets of different sizes, possible future realizations are usually expressed as possible future returns:  Possible future returns = (possible future realization – current value) / (current value) What You Should Know Return to menu

26. 26 Risks and Returns  The larger the risk, the bigger the expected return:  Assuming the risk can not be diversified away and the asset holders are not risk seekers.  Generally, if enough buyers perceive risk has increased, prices will decrease to compensate buyers for assuming risk, which increases expected returns.  When you hear someone say “risk and reward” go together, you should interpret this more precisely as “risk and expected return” go together. What You Should Know Return to menu

27. 27 Risks and Returns  The larger the risk, the bigger the expected return: What You Should Know Return to menu

28. 28 Risks and Returns Answer the following questions from the perspective of a representative student in your group:  What investments have you and others made in your human capital, and thus, what is at risk?  How will the returns on these investments be realized in the future?  What can you do to manage the risks and rewards, and thus, the expected returns associated with these investments? Questions Return to menu

29. 29  Compare the risks and expected returns of Intel’s cash and inventories and what Intel can do to manage them. Question Return to menu Risks and Returns

30. 30 Risks and Returns  The expected return on an entity’s assets is the combined amount debt holders and owners expect to receive beyond the amount invested in the assets.  Risks and expected returns go together:  The higher the risk that investors perceive when they are considering an investment,  The higher the expected return they will require to compensate for this risk.  The realized return on an entity’s assets is the combined amount debt holders and owners actually receive above and beyond the amount invested. Take Aways Return to menu

31. 31 Financial Leverage and its Consequences  Financial leverage is the extent to which assets are financed by liabilities rather than equity.  Leverage is measured as liabilities/assets or by comparable ratios involving assets, liabilities, and owners’ equity.  The consequences of financial leverage depend on:  The magnitude of the financial leverage and  The risks and rewards associated with the assets Things You Need to Know Return to menu

32. 32 Financial Leverage and its Consequences  From the owners’ perspective, assets’ risks and rewards are amplified by financial leverage.  The reason for this amplification is owners must pay the same amount to creditors to meet obligations regardless of the value realized from the assets. Things You Need to Know Return to menu

33. 33 Financial Leverage and its Consequences Answer the following questions from the perspective of a representative student in your group:  Is the financial leverage associated with your assets, liabilities, and owners’ equity low, medium, or high?  Are the consequences of this financial leverage, low, medium, or high?  If your answers differ for the above questions, why do they differ? Questions Return to menu

34. 34 Financial Leverage and its Consequences  Excessive financial leverage is frequently cited as a primary cause of the recent economic crisis.  What was the problem: increased financial leverage, increased asset risk, both?  What can we conclude about the information and mechanisms that were in place to manage the consequences of leverage prior to the crisis:  Incentives?  Monitoring and communication?  Plans, policies, training, contracts, and controls? Questions Return to menu

35. 35 Financial Leverage and its Consequences  Financial leverage amplifies the owners’ share of the risks and rewards associated with a company’s assets.  Financial leverage ratios often differ greatly across industries because of differences in asset risks.  Analyzing the consequences of financial leverage can be particularly problematic when assets and liabilities are not recognized on balance sheets:  Off-balance sheet financing often occurs when assets and liabilities can not be measured reliably, which also tends to be when there is considerable risk.  Prior to recent changes in GAAP, off-balance sheet financing also occurred frequently when companies entered into complex contractual arrangements (securitizations) that allowed them to recognize smaller related assets and liabilities. Take Away Return to menu

36. 36 Closing Thoughts  A basic tenant of modern finance is risks and rewards go together. There are some important implicit assumptions behind this concept:  Investors know how to assess risk and rewards, pursue their economic self interests rationally within the confines of social norms and laws, and are risk averse or risk neutral.  The risks are limited to those associated with measurable uncertainty, meaning limited to possible outcomes and probabilities that can be specified in advance.  Insiders’ and outsiders’ perceptions about risks and rewards can vary greatly depending on their access to related information and the ways they process this information, as can perceptions among outsiders.  Analyzing the consequences of financial leverage ratios without analyzing asset risk is a recipe for disaster. Return to menu