Financial Management-Chapter02

1Section1:IntroductionfinanceandfinancialmarketsSection2:RiskandreturnSection3:TimevalueofmoneySection4:BondandstockvaluationSection5:ThecostofcapitalSection6:CapitalbudgetingdecisionmethodsSection7:LeverageanddividendpolicySection8:WorkingcapitalpolicySection9:Short-termfinancingSection10:Projectpresentation&revision2LearningObjectivesDefinerisk,riskaversion,andtherisk-returnrelationshipCalculateexpectedvalue,variance,standarddeviationandco-efficientofvariationIdentifythetypesofrisksabusinessfirmencountersExplainthemethodsofriskreductionCalculatetheexpectedreturn,standarddeviation,andco-efficientofvariationonaportfolioofsecuritiesDescribethecapitalassetpricingmodelanddiscusshowitisusedTextbookReference:Chapter73Riskisthepotentialforunexpectedeventstooccur.Inmakinginvestments,thereisuncertaintyaboutthecashflowsthatwillbereceivedinthefuture.4Riskaversionisthetendencytoavoidadditionalrisk.Mostpeople,whenfacedwiththechoicebetweenmoreriskorless,willchoosethelessriskyalternative,allelseequal.Riskaversionmeansthatpeoplewillnotbewillingtobearriskunlesstheyaresufficientlycompensatedforit.Themorerisktheytakeon,themorereturntheywillrequirefromaninvestment.5therisk-returnrelationship:Thepositivebetweenriskandreturn6Questions:Howcanwemeasurerisk?Howcanweestimatetherateofreturninvestorsrequireforprojectswiththisrisklevel?7Onemeasureofriskisthedegreetowhichactualoutcomesmaydeviatefromexpectedoutcomes.Thewiderdispersedthepotentialoutcomesarearoundthemean,orexpectedvalue,themoreriskthereisthatyouractualoutcomewillbedifferentfromwhatyouexpect.8Theexpectedvalue,ormean(μ)ismeasuredas:niiiPV1)(Where,Viisthepossiblevalueofsomevariable;PiistheprobabilityofvalueVioccurring.9Thestandarddeviation,whichisameasureofdispersionaroundthatexpectedvalueismeasuredby:niiiVP12)(10Thegreaterthestandarddeviation,thewiderthedistributionofpossiblereturnsaroundthemean.Ifthevaluesarenormallydistributed,itispossibletousethestandarddeviationtomakesomegeneralconclusionaboutlikelyoutcomesusingthemeanandstandarddeviation.Innormaldistributions,thereisproximatelya67percentchancethattheobservedvaluewillbewithinonestandarddeviationofthemeananda95percentchancethatitwillbewithin2standarddeviationofthemean.11Sincethestandarddeviationismeasuringdeviationrelativetoaparticularmeanvalue,standarddeviationfordistributionswithdifferentmeansarenotdirectlycomparable.Tocomparetheriskinessoftwodistributionsthathavetwodifferentmeans,itispreferabletousethecoefficientofvariation(CV)asameasureofriskrelativetothemean.12MeanDeviationStandardCVThecoefficientofvariationrepresentsthestandarddeviation’spercentageofthemean.Thecoefficientofvariation(CV)measuresrelativerisk.13Example:InvestorsinHoevenIndustriescommonstockhavea0.2probabilityofearningareturnof4percent,a0.6probabilityofearningareturnof10percent,anda0.2probabilityofearningareturnof20percent.1whatisthemeanofthisprobabilitydistribution?(theexpectedrateofreturn)2whatisthestandarddeviationfortheHoevenIndustriescommonstock?3calculatethecoefficientofvariation(CV)forthisdistribution.14Answers:μ=(0.2×0.04)+(0.6×0.10)+(0.2×0.2)=0.108=10.8%%15.50515.0)108.020.0(2.0)108.010.0(6.0)108.004.0(2.0222%69.474769.0108.00515.0CV15Theformsofriskthatbusinessesmostoftenencounterarebusinessrisk,financialrisk,andportfoliorisk.16BusinessRiskFinancialRiskPortfolioRiskBusinessriskreferstouncertaintyofoperatingincome(earningsbeforeinterestandtaxes,orEBIT),whichisgenerallyrelatedtosalesvolatility.Businessriskwilldependonmanyfactorsincludingthetypeofbusiness,thesizeofthefirm,andtheexistenceoffixedcostsintheoperationsofafirm.thehigherthecoefficientofvariationofpossibleoperatingincomevalues,thegreaterthebusinessriskoffirm.Fixedoperatingcostssuchasrentandinsurancepremiumsintensifybusinessrisk.17Operatingleverage:thetendencyoffixedexpensestomagnifybusinessrisk.Forfirmswithhighfixedexpenses,changesinsaleswillproducegreaterchangesinoperatingincome.Aswithothertypesofrisk,greaterriskofthistypegenerallyimpliesgreaterexpectedreturnsforthefirm.18BusinessRiskFinancialRiskPortfolioRiskFinancialrisk=CVofnetincomewithinterestexpense–CVofnetincomewithoutinterestexpenseFinancialriskoccurswhencompaniesborrowmoneyandincurfixedinterestcharges.Financialrisk,orfinancialleverageistheadditionalvolatilityofafirm’snetincomecausedbythefixedexpense.Financialriskcanbemeasuredbytheincreaseincoefficientofvariationofnetincome.19BusinessRiskFinancialRiskPortfolioRiskTheexpectedreturnofaportfolioistheweightedaverageofthereturnsoftheindividualassetsintheportfolio.Aportfolioisanycollectionofassetsmanagedasagroup.20))E(R(w))E(R(w)E(RBBAApForatwoassetportfoliocontainingassetsAandB,theexpectedreturnofaportfoliocanbecalculatedas:21DiversificationEffect1、Whenassetsarecombinedinagroup,theriskofthegroupisoftenlowerthantheriskoftheindividualsecuritiesbecausethebusinessrisksforeachdon’thappensimultaneously.2、Thesmoothingofvariationsinexpectedreturnoftheportfolioascomparedtothoseoftheindividualsecuritiesiscal