Module 7

Risk and Company Investment

Decisions
 Risk and Individuals
• Risk is a measure of variability. It is best measured by the
standard deviation of rates of return on the entire
portfolio of assets. This is a measure of the extent to which
the portfolio’s possible outcomes are likely to be different
from its mean or expected average outcome.
• Standard deviation is found by first finding the ‘mean’ or
average expected return. To calculate the mean or average
expected return we multiply the rates of potential return
by the probability of their occurrence. The sum of these
products provides the mean. We then subtract each
potential outcome from the mean return, square those
differences, multiply these differences by the likelihoods of
their occurring, add them up and take the square root.
 Risk, Return and Diversification
• The average expected return of a portfolio is the sum
of the weighted average return of each asset in the
portfolio.
• Risk/Standard Deviation – portfolio risk is not the same
as average individual security risk, risk reduction
through diversification is the reason. The more
positively related are securities’ returns within a
portfolio, the less there will be to gain from
diversification. The less positively related are the
returns from assets in a portfolio, the greater will be
the reduction in risk relative to average individual
asset risk.
 Risk, Return and Diversification
1) When individual assets are held in a portfolio, the risk associated
with the portfolio is not likely to be simply the average risk of the
assets of the portfolio.
2) The detailed interactions of individual asset returns, their return
distributions, and the return distributions of a portfolio formed
from them can be seen by developing the joint probability
distribution of the assets in question.
3) The risk of individual assets, depending upon how their returns
are related, will to some extent cancel each other out when a
portfolio of these assets is formed.
4) The extent to which that risk will cancel depends upon how
positively the returns of the constituent individual assets are
related. One way to measure that relatedness is by the correlation
coefficient of paired returns of the assets or securities within the
portfolio.
 The Market Model and Individual
Asset Risk
• The standard deviation of return on an individual
asset is only an appropriate risk measure for that
asset when it is held by itself, and not in a
portfolio. When included in a portfolio, it is likely
that some of that asset’s risk will be diversified
away.
• It follows therefore, the only risk that is relevant
is the risk that cannot be diversified away which
we call undiversifiable or systematic risk.
• Note also that the higher the number of shares in
a portfolio the greater the diversification
benefits.
 The Market Model and Individual
Asset Risk
• Beta Coefficient - expresses the relationship between
the return expected from holding a security and that
expected from the market as a whole.
• A beta of 1.0 tells us that the security moves exactly
with the market, e.g. If the market increases by 10%
the return on the asset will increase by 10%.
• Another example, a security currently expected to
have a 15 per cent return would, with a beta of 1.3
and with the market return increasing from 12 per
cent to 14 per cent, experience an increase in its
expected return from 15 percent to (15% + 1.3 (14% −
12%) =) 17.6 per cent.
The Market Model or Security Market
Line
• If participants in financial markets understand
the principles of diversification, and if market
prices of securities reflect this, the only risk that
will receive compensation in the form of higher
expected returns is undiversifiable or systematic
risk. All of the rest is diversified away, and in a
competitive marketplace such diversifiable risk
will not affect the returns of individual securities.
• How do we go about setting the required return
on a asset. See figure 7.6
 Recap
1) The total risk of an individual asset or security can be separated into two
types of risk, that which can be diversified away, and that which cannot.
2) The risk that cannot be diversified away is related to an underlying
‘market factor’ that is common to all assets and securities, and is thus a
common correlation limiting the amount of risk reduction through
diversification that is possible by including a security in a portfolio.
3) This undiversifiable or systematic risk can be measured by the beta
coefficient (standard deviation times correlation with the market) of the
security in question.
4) If the financial market sets securities’ returns based upon their risks
when held in well diversified portfolios, systematic risk will be the
appropriate measure of risk for individual assets and securities, and the
SML will dictate the set of risk adjusted returns available in the market.
5) These SML based returns are the opportunity costs of capital suppliers
of companies, and thus can form the basis for evaluating internal
company investments. These investments must offer returns in excess of
capital suppliers’ opportunity costs in order to be acceptable.
 Using the Capital Asset Pricing Model in Evaluating
Company Investment Decisions

• Lets look at Figure 7.7 on page 7/17

• A company should not generally apply its
WACC as an investment criterion. The WACC
will give the correct answer only when an
investment’s risk is the same as the average
risk of the entire company.
• Risk categories include cost saving, expansion
or new product.
 Estimating Systematic Risk of
Company Investments
• If the project is of the same risk as the overall
company we can use the company beta.
• If the project’s risk is different from the average risk
of the company then the beta coefficient of other
traded companies with the same systematic risk can
be used.
• Most times however a traded company with the
same systematic risk is not available and therefore a
beta coefficient will have to be constructed.
 Estimating Systematic Risk of
Company Investments
• Procedure
• Begin with a ‘benchmark’ coefficient (from a company or
division that can be either similar to or different from the
project in question) and then successively multiply that
coefficient by the ratios of the project’s volatilities to those of
the benchmark. (Volatility emanate from revenue sensitivity
and proportion of fixed costs in the company’s operations.)
1) Ungear the beta
2) Adjust for revenue sensitivity
3) Adjust for operational gearing
4) Re - gear the beta
See page 7/20