1. ACC09 FINANCIAL MANAGEMENT PART 2
RISK AND RETURNS
ACC09 FINANCIAL MANAGEMENT PART 2

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.
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3. Effect of Market Diversification to Firm-Specific and Market Risks

4. Risk-Return Trade-off
The RETURN earned on investments represents the marginal benefit of investing.
Risk represents the marginal cost of investing.
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5. 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

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

7. EXPECTED VALUE OF RETURNS
Estimating the various amounts of cash receipts from the project each year under different assumptions or operating con­ditions
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.

8. EXPECTED VALUE OF RETURNS
The GREATER the Expected Value or Pay-off, the BETTER.

9. MEASUREMENTS OF RISK Variance Standard Deviation (SD)
Coefficient of Variation (CV)
Beta
Covariance

10. 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
FOR UNGROUPED DATA
Standard deviation – a measure of volatility in percentage terms
© 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.

11. 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
FOR GROUPED DATA
Standard deviation – a measure of volatility in percentage terms
© 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.

12. 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.

13. EXERCISE 1
Year
ONE
 TWO
200A
80.95
58.26
200E
32.02
2.94
200I
11.67
48.64
200B
-47.37
-33.79
200F
25.37
-4.29
200J
36.19
23.55
200C
31.00
29.88
200G
-28.57
28.86
200D
132.4
30.35
200H
0.00
-6.36
The average return over the ten years is 27.37% for ONE and 17.8%.
for TWO. Variance is (one) and (two). The standard deviations are 51.36% and 27.89% respectively.
Estimate the EXPECTED RETURN, VARIANCE, and STANDARD DEVIATION in annual returns in each company

14. 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 (σi) 2 + w22 (σ2) (wi)(σi) (w2)(σ2) (r2)
=wi2 (σi) 2 + w22 (σ2) (wi) (w2)(Cov)
The SD is equal to the square root of the variance of the portfolio.

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

16. 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

17. 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 (σi) 2 + w22 (σ2) (wi)(σi) (w2)(σ2) (r2)
=wi2 (σi) 2 + w22 (σ2) (wi) (w2)(Cov)
How would one compute for Cov?

18. 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.

19. EXERCISE 2
Year
ONE
 TWO
200A
80.95
58.26
200E
32.02
2.94
200I
11.67
48.64
200B
-47.37
-33.79
200F
25.37
-4.29
200J
36.19
23.55
200C
31.00
29.88
200G
-28.57
28.86
200D
132.4
30.35
200H
0.00
-6.36
If the correlation of these two investments is , estimate the variance of a portfolio com­posed, in equal parts, of the two investments.

20. ILLUSTRATIVE PROBLEM 1 Expected or Average Stock Return
Demand for the
company's products
Probability of this
demand occurring
Rate of Return on stock
if this demand occurs
Company 1
Company 2
Strong
0.30
100%
20%
Normal
0.40
15%
Weak
-70%
10%
1.00
Expected or Average Stock Return
Variance of Stock returns of each
Standard Deviation of Stock returns of each

21. ILLUSTRATIVE PROBLEM 2 Coefficient of Variation of each Covariance
Demand for the
company's products
Probability of this
demand occurring
Rate of Return on stock
if this demand occurs
Company 1
Company 2
Strong
0.30
100%
20%
Normal
0.40
15%
Weak
-70%
10%
1.00
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 compute for the: (A)Variance of 2-Asset Portfolio (B) Standard Deviation of the 2-Asset Portfolio

22. The Variability of Stock Returns
Beta Estimate (β) 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) β i
The SML commonly adopts the CAPM model

23. The Variability of Stock Returns
If β = 1.0, then the Asset is an average asset.
If β > 1.0, then the Asset is riskier than average.
If β < 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

24. The Variability of Stock Returns
The Hamada equation below is used to compute for new beta shall there be changes in capital structure.
β u= Current, levered β
[1 + {(1-tax rate)(Debt/Equity)}]
Most stocks have betas in the range of 0.5 to 1.5

25. ILLUSTRATIVE PROBLEM 2
In December 200B, AAA’s stock had a beta of 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

26. ILLUSTRATIVE PROBLEM 2 Estimate the expected return on the stock.
In December 200B, AAA’s stock had a beta of 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.

27. ILLUSTRATIVE PROBLEM 2
In December 200B, AAA’s stock had a beta of 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 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 beta.

28. ILLUSTRATIVE PROBLEM 2
In December 200B, AAA’s stock had a beta of 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?

29. ILLUSTRATIVE PROBLEM 3
Assume that the treasury bill rate is 8% and the stock’s risk premium is equal to 7%.
1.Use SML to calculate the required returns
Securities
Expected Returns
Beta A
17.4%
1.29 B
13.8
0.68 C
1.7
-0.86 D
8.0
0.00 E
15.0
1.00

30. ILLUSTRATIVE PROBLEM 3
2. Compare the required returns and the expected returns, determine which securities are to be bought.
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 number 3 above
Securities
Expected Returns
Beta A
17.4%
1.29 B
13.8
0.68 C
1.7
-0.86 D
8.0
0.00 E
15.0
1.00

31. 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?

32. 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.

33. Homework 1 Compute for the expected return
Estimate the average annual return you would have made on your investment
Estimate the standard deviation and vari­ance in annual returns.
Year
Price
Dividends
200A
36.10
3.00
200E
26.80
1.60
200I
24.25
200B
33.60
200F
24.80
200J
35.60
200C
37.80
200G
31.60
200D
30.90
2.30
200H
28.50

34. 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

35. homework 3
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 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.
a. Unlevered Beta for Novell = 1.50 ! Firm has no debt
Unlevered Beta for WordPerfect = 1.30 ! Firm has no debt
Unlevered Beta for Combined Firm = 1.50 (2/(2+1)) (1/(2+1)) = 1.43
This would be the beta of the combined firm if the deal is all-equity.

36. homework 2
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 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