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Discussion Questions

13-1. Risk-averse corporate managers are not unwilling to take risks, but will require a higher return from risky investments. There must be a premium or additional compensation for risk taking. 13-2. Risk may be defined in terms of the variability of outcomes from a given investment. The greater the variability, the greater the risk. Risk may be measured in terms of the coefficient of variation, in which we divide the standard deviation (or measure of dispersion) by the mean. We also may measure risk in terms of beta, in which we determine the volatility of returns on an individual stock relative to a stock market index. 13-3. The standard deviation is an absolute measure of dispersion, while the coefficient of variation is a relative measure that allows us to relate the standard deviation to the mean. The coefficient of variation is a better measure of dispersion when we wish to consider the relative size of the standard deviation or compare two or more investments of different size. 13-4. Risk may be introduced into the capital budgeting process by requiring higher returns for risky investments. One method of achieving this is to use higher discount rates for riskier investments. This risk-adjusted discount rate approach specifies different discount rates for different risk categories as measured by the coefficient of variation or some other factor. Other methods, such as the certainty equivalent approach, may also be used. 13-5. Referring to Table 13-3, the following order would be correct: repair old machinery (c) new equipment (a) addition to normal product line (f) new product in related market (e) completely new market (b) new product in foreign market (d)

13-6. In order to minimize risk, the firm that is positively correlated with the economy should select the two projects that are negatively correlated with the economy. 13-7. A discount rate combines the effects of risk and time value of money in one evaluation tool. A certainty equivalent deals first with risk by converting uncertain cash flows to certainty equivalents, and then discounts at the risk free rate to consider the time value of money.

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13-8. Simulation is one way of dealing with the uncertainty involved in forecasting the outcomes of capital budgeting projects or other types of decisions. A Monte Carlo simulation model uses random variables for inputs. By programming the computer to randomly select inputs from probability distributions, the outcomes generated by a simulation are distributed about a mean and instead of generating one return or net present value, a range of outcomes with standard deviations are provided. 13-9. Sensitivity analysis only adjusts one variable at a time. In all likelihood variables are interdependent and if one changes the others will likely change as well. Sensitivity analysis misses this dynamism. As well sensitivity analysis does not assess risk, it only points out possible outcomes and we are left to assign probabilities. With todays ease of spreadsheet production on the PC one can turn out endless analysis, which, without a plan will become meaningless. 13-10. Decision trees help lay out the sequence of decisions that are to be made and present a tabular or graphical comparison resembling the branches of a tree which highlights the difference between investment choices. 13-11. The firm should attempt to construct a chart showing the risk-return characteristics for every possible set of 20. By using a procedure similar to that indicated in Figure 13-11, the best risk-return trade-offs or efficient frontier can be determined. We then can decide where we wish to be along this line. 13-12. High profits alone will not necessarily lead to a high market value for common stock. To the extent large or unnecessary risks are taken, a higher discount rate and lower valuation may be assigned to shares. Only by attempting to match the appropriate levels for risk and return can we hope to maximize our overall value in the market.

1. www.standardandpoors.com www.bankofcanada.ca/en

S-426

D = DP

P 2 12 22 14 50

DP

= D

2

b. D 20 40 55 70

D 50 50 50 50

= (D D ) P

(D D ) 30 10 + 5 + 20 (D D )2 900 100 25 400 P .10 .30 .40 .20 (D D )2P 90 30 10 80 210

= 210 = 14.49

13-2. a. 40 60 140 D .20 .50 .30 Shack Homebuilders Limited

D = DP

P 8 30 42 80

DP

= D

S-427

b. D 40 60 140

D 80 80 80

= (D D ) P

2

(D D ) 40 20 + 60

= 1,600 = 40.0

13-3.

Five alternatives

Coefficient of variation (V ) =

A B C D E $1,200/ $5,000 $600/ $4,000 $800/ $4,000 $3,200/ $8,000 $800/ $10,000 = .24 = .15 = .20 = .40 = .08

13-4. You would not need to use the coefficient of variation. Since B and C have the same expected value, they can be evaluated based solely on their standard deviations of return. C has a larger standard deviation and so is riskier than B for the same expected return.

S-428

Sensor Technology Standard Deviation 31 52 83 146 Coefficient of Variation .34 .43 .55 .73

b. Yes, the risk appears to be increasing over time. This may be related to the inability to make forecasts far into the future. There is more uncertainty. 13-6. Stocks Bonds Commodities Options Tim Trepid & Mike Macho Coefficient of variation $4,000/ $7,000 0.57 $1,560/ $5,000 0.31 $15,100/ $12,000 1.26 $8,850/ $8,000 1.11

a. Tim should select bonds, which have the least risk. b. Mike should select commodities, which have the greatest risk.

13-7. Construction Project A B C D $138,000/ $262,000 $403,000/ $674,000 $108,000/ $88,000 $207,000/ $125,000

Wildcat

Oil

&

Richmond

a. Wildcat Oil should select project D, which has the greatest risk. b. Richmond Construction should select project A, which has the least risk.

Foundations of Fin. Mgt.

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13-8. Alternative 1 D P = DP $50 .2 $10 80 .4 32 120 .4 48 D = $90 Standard Deviation: Alternative 1: D D $50 90 80 90 120 90

Three Investment Alternatives Alternative 2 D P = DP $90 .3 $27 160 .5 80 200 .2 40 D = $147 Alternative 3 D P = DP $80 .4 $32 200 .5 100 400 .1 40 D = $172

(D D ) 40 10 + 30

P .20 .4 .4

= 720 = 26.83

Alternative 2: D D $90 $147 160 147 200 147 (D D ) 57 + 13 + 53 (D D )2 3,249 169 2,809 P .3 .5 .2 (D D )2P $974.70 84.50 561.80 $1,621.00

= 1,621 = 40.26

Alternative 3: D D $80 $172 200 172 400 172 (D D ) $-92 +28 +228 (D D )2 $8,464 784 51,984 P .4 .5 .1 (D D )2P $3,385.60 392.00 5,198.40 $8,976.00

= 8,976 = 94.74

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Rank by Coefficient of Variation: least risk to most 40.26 Alternative 2 (V ) = = = 0.274 147 D

Alternative 1 Alternative 3

(V ) =

D D

= =

(V ) =

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13-9.

Bridgets Modeling Studios Standard Deviations of Sites A and B Site A D $80 110 140 220 (D D )2 $1,600 100 400 10,000 (D D )2P $ 240 50 120 500 $ 910

= 910 = $30.17

Site B D $50 80 120 160 190 (D D )2 $4,900 1,600 0 1,600 4,900 (D D )2P $ 490 320 0 320 490 $1,620

= 1,620 = $40.25

VA VB = = $30.17/$120 $40.25/$120 = = .2514 .3354

Site A is the preferred site since it has the smaller coefficient of variation. Because both alternatives have the same expected value, the standard deviation alone would have been enough for a decision. A will be just as profitable as B but with less risk.

S-432

13-10.

Micro Systems

The coefficient of variation suggests a discount rate of 12%. Year 1 2 3 4 5 Cash flow $ 9,000 12,000 18,000 16,000 24,000 PV of cash flows Investment NPV PV@12% $ 8,036 9,566 12,812 10,168 13,618 54,200 50,000 $ 4,200

Based on a positive NPV, the project should be undertaken. 13-11. Product 1 Year Cash flow 1 $25,000 2 30,000 3 38,000 4 31,000 5 19,000 PV of Inflows Investment NPV Select Product 1

The instructor may wish to point out that Product 2 has higher undiscounted total cash flows than Product 1 (the numbers are $171,000 versus $143,000), but has a lower NPV because of the higher discount rate.

Payne Medical Labs Product 2 PV@10% $22,727 24,793 28,550 21,173 11,798 $109,041 90,000 $ 19,041 Year 1 2 3 4 5 Cash flow $16,000 22,000 34,000 29,000 70,000 PV@15% $13,913 16,635 22,356 16,581 34,802 $104,287 90,000 $ 14,287

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13-12.

a. Expected Cash Flow Cash Flow $3,600 5,000 7,400 9,800 P .2 .3 .4 .1 $ 720 1,500 2,960 980 $6,160

b. NPV (Net Present Value) $6,160 (%i = 11%, n = 5) = $22,767 $ 22,767 25,000 $(2,233) Present value of inflows Present value of outflows Net present value

IRR (Internal Rate of Return) Calculator: Compute: PV = $25,000 %i =? %i = 7.38% FV = 0 N=5 PMT = $6,160

c. Debby should not buy this new equipment because the net present value is negative and the internal rate of return is less than the cost of capital. The answer assumes that Debbys probability distribution of the possible outcomes is accurate.

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13-13.

a. Calculate the net present value for each project. The Yukon Mine Years Cash Flow 5-15 $400,000 16-25 $800,000 Present value of inflows Present value of outflows NPV (Net present value) The Labrador Mine Years Cash Flow 1-25 $300,000 Present value of inflows Present value of outflows NPV (Net present value)

Both projects are attractive based on positive NPVs. Select the Yukon Mine if projects are mutually exclusive. b. Recalculate the NPV of the Yukon Mine at a 15% discount rate. The Yukon Mine Years Cash Flow 5-15 $400,000 16-25 $800,000 Present value of inflows Present value of outflows NPV (Net Present Value) Present Value @ 15% $1,196,957 $ 493,423 $1,690,380 $2,000,000 $ (309,620)

S-435

13-14. a. Wrigley Village D P 10 .10 30 .20 40 .30 50 .30 60 .10 Expected cash flow (thousands)

D = DP

Crosley Square D P 20 .10 30 .30 35 .40 50 .20 Expected cash flow (thousands) DP $2 9 14 10 $35

DP $1 6 12 15 6 $40

D $40 40 40 40 40

Coefficient of variation (V ) =

S-436

D $20 30 35 50

D $35 35 35 35

= 75 = 8.66 thousands

Coefficient of variation (V ) =

Based on the coefficient of variation, Wrigley Square has more risk (0.336 vs. 0.247). 13-15. Mr. Monty Terry (Continued)

a. Risk-adjusted net present value Wrigley Village Crosley Square With V = 0.336, With V = 0.247, discount rate = 11% discount rate = 8% $40,000 $35,000 $336,870 300,000 $ 36,870 $373,617 300,000 $ 73,617

Expected cash flow IFPVA (n = 25) Present value of inflows Present value of outflows Net present value

b. If these two investments are mutually exclusive, he should accept Crosley Square because it has a higher net present value. If the investments are non-mutually exclusive and no capital rationing is involved, they both should be undertaken.

Foundations of Fin. Mgt.

S-437

Allisons Dresswear Manufacturers (2) (3) (4) Present Value of cash flows Probability from sales Initial cost .20 $180,000 $110,000 .60 .20 130,000 85,000 110,000 110,000

(5)

(6) Expected NPV (2) (5) $14,000 12,000 (5,000) $21,000 $70,000 21,000 (50,000) $41,000

$300,000 230,000 0

b. The indicated investment, based on the expected NPV, is in the Cashmere sweater line. However, there is more risk in this alternative so further analysis may be necessary. It is not an automatic decision.

S-438

13-17.

a. $32,000 to $48,000 expected value + 1 0.6826 = 68.26% b. $28,000 to $52,000 expected value + 1.5 0.8664 = 86.64% c. greater than $32,000

34% Total distribution under the curve: .3413 .5000 .8413 = 84.13%

S-439

$55,680 $40,000 $15,680 = = +1.96 This represents 0.4750 or $8,000 $8,000 48%.

Total distribution under the curve: .4750 .5000 .9750 = 97.50% e. Less than $32,000 or greater than $52,000

$32,000

$52,000

$52,000 $40,000 $12,000 = = +1.5 This represents 0.4332 or 43% $8,000 $8,000

Total distribution under the curve, in the tails: 0.5000 0.3413 = 0.1587 + 0.5000 0.4332 = 0.0668 = 0.2255 = 22.55%

Foundations of Fin. Mgt.

S-440

13-18.

D 60 60 60

(D D ) 10 0 + 10

= 40 = 6.32

Standard deviation: year 5 D 40 60 80

D 60 60 60

(D D ) 20 0 + 20

(D D )2 400 0 400

= 200 = 14.14

Standard deviation: year 10 D 30 60 90

D 60 60 60

(D D ) 30 0 + 30

(D D )2 900 0 900

= 540 = 23.24

S-441

S-442

c. Table: Year (1) PVIF 5% 1 5 10 .952 .784 .614 (2) PVIF 10% .909 .621 .386 (3) PVIF Difference .043 .163 .228

d. Yes. The larger risk over time is consistent with the larger differences in the present value interest factors (PVIFs) over time. In effect, future uncertainty is being penalized by a lower present value interest factor (PVIF). This is one of the consequences of using progressively higher discount rates to penalize for risk. e. NPV Year 1 5 10 Inflow $60 60 60 PV of inflows Investment NPV Accept the investment. PV @ 10% $ 54.5 37.3 23.1 $114.9 110.0 $ 4.9

S-443

13-19.

a. Purchase of the Toy Company would provide some reduction in risk because of the low correlation with Gifford Western Wear, while purchase of Boot Company would do very little to reduce portfolio risk because of the high correlation coefficient. A combination with the Jewelry Company would provide a fairly large degree of risk reduction. b. Students may or may not calculate the coefficient of variation to get some idea about the riskiness of each project. If they do, they will find the following: VGWW = $3/ $10 = 0.3 VToy = $6/ $10 = 0.6 VBC = $5/ $10 = 0.5 VJC = $7/ $10 = 0.7

Although the Jewelry Company has the highest risk as measured by the coefficient of variation, its negative correlation coefficient of 0.6 should provide the best risk reduction for Gifford Western Wear. This is an example of a risky company being added to a portfolio but reducing total risk. Buy the Jewelry Company. c. Since the Boot Company is most like Gifford Western Wear, its selection would provide the least amount of risk reduction. Therefore, add the Toy Company to the Jewelry Company selected in part (b). The Toy Company offers the next best risk reduction after the Jewelry Company because of its low positive correlation coefficient. You might also want to know more about the relationship of the other companies to each other.

S-444

13-20.

D = DP

P DP 6 16 18 $40($ millions)

= (D D ) P

2

D $20 40 60

D 40 40 40

(D D ) 20 0 + 20

(D D )2 400 0 400

= 240 = 15.49

Coefficient of variation

After the acquisition:

(V ) =

15.49 = 0.388 40

Expected value 43.0 ($ millions) Standard deviation 27.2 ($ millions) Coefficient of variation 0.633

higher, the coefficient of variation is more than twice as high (.633 vs. 388). The slightly added return probably does not adequately compensate for the added risk. c. Probably not. There may be a higher discount rate applied to the firm's earnings to compensate for the additional risk. The share price may actually go down. d. The oil company may provide the best diversification benefits. Since petroleum is used as part of the firms production process, an increase in the price of oil would normally hurt the chemical company, but this would be offset by the increased profits for the oil company. The same type of

S-445

offsetting risk reduction benefits would take place if the price of oil were going down.

S-446

13-21.

Jimmy

a. Investment D is riskier by itself with the higher standard deviation (5.2% vs. 4.1%), and D is also riskier in a portfolio context as its beta is higher (1.25 vs. 0.94). b. D = 0.4 0.18 + 0.60 0.14 = 0.072 + 0.084 = .156 = 15.6%

DE = 0.4 2 0.052 2 + 0.6 2 0.0412 + 2 0.55 0.052 0.041 0.4 0.6 c. DE = 0.0400081 = 4.0%

d. = 0.4 1.25 + 0.6 0.94 = 1.064 e. The standard deviation of the portfolio is less than either investment

individually. The key variable in determining the portfolio standard deviation is the correlation coefficient (how the two investments move together). The portfolio beta is an easier calculation of risk than the portfolio standard deviation.

13-22.

Astrid

a. Investment N is riskier by itself with the higher standard deviation (3.9% vs. 3.1%). However M is also riskier in a portfolio context as its beta is higher (1.40 vs. 0.85). b. D = 0.55 0.12 + 0.45 0.19 = 0.066 + 0.0855 = .1515 = 15.15%

DE = 0.55 2 0.0312 + 0.45 2 0.039 2 + 2 0.30 0.031 0.039 0.55 0.45 c. DE = 0.027897 = 2.79%

d. = 0.55 1.40+ 0.45 0.85 = 1.1525 e. The standard deviation of the portfolio is less than either investment

individually. The key variable in determining the portfolio standard deviation is the correlation coefficient (how the two investments move together). Beta is an easier calculation of risk than the portfolio standard deviation.

S-447

13-23. a. Albert

D = DP

2

= 20%

= (D D ) P

D 0.10 0.20 0.50

D .20 .20 .20

(D D )2 .09 0 .09

China D 0.10 0.10 0.10 P .30 .40 .30

2

= 10%

= (D D ) P

D 0.10 0.10 0.10

D .10 .10 .10

(D D ) 0 0 0

(D D )2 0 0 0

(D D )2P 0 0 0 0

= 0 = 0 = 0%

S-448

covAC = (D (F ) P 0.10 0.10 .30 0.10 0.10 .40 0.10 0.10 .30 covAC = 0 =0

D i) (F

) 0 0 0 0

c.

2AC

S-449

13-24. . a. Alpha

D = DP

2

= 17.5%

= (D D ) P

D 0.25 0.20 0.15 0.10

D .175 .175 .175 .175

Omega D 0.10 0.15 0.20 0.25

D = DP

2

= 17.5%

= (D D ) P

D 0.10 0.15 0.20 0.25

D .175 .175 .175 .175

S-450

b. (D D ) 0.25 0.175 0.20 0.175 0.15 0.175 0.10 0.175 covAO = (D (F ) P 0.10 0.175 .10 0.15 0.175 .40 0.20 0.175 .40 0.20 0.175 .10

D i) (F

2AC = (.5)2(.001625) + (.5)2 (001625) + 2( .0016250)(.5)(.5) 2AC

AC = 0 AC = 0 = 0%

S-451

13-25. a. b.

Return (percent) 17

Mr. Boone

16 15 14 13 12 11

B C D F G E

10 0 1

4 5 6 Risk (percent)

c. Achieve the highest possible return for a given risk level. Allow the lowest possible risk at a given return level. d. No. Each investor must assess his or her own preferences about their risk and return trade-off.

S-452

S-453

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