Manhal A.

Jaweesh
University of Leicester MBA
Finance and Growth Strategy- Module 4 assignment

Portfolio Risk and Cash Flow Discounting

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Content

Abstract…………………………………………….. 3
Introduction………………………………………… 4
Types of Risk…………………………………. … 5
Measuring Risk………………………………………………… 6
Discussion……………………………… ……………………… 8
Discounting Future Cash Flow …….……………………. 9
Project Assessment…………. …….……………………. 11
Conclusion……….…………. …….……………………. 12
References………………………………………….. 13

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ABSTRACT

This paper shed a light on the nature of the systematic, unsystematic and total risk that
the investor must be aware of and the way of measuring each type of these risks prior
to decision making on any investment.
In light of the above, the paper also attempt to explain the importance of time value of
money and the discounting future cash flow as a very important tool to incorporate the
rate of return required by the investor.
It is also, addresses the methods used in measuring the systematic, unsystematic, and
total risk where the result reveal that unsystematic risk can be diversified and reduce
by forming an efficient portfolio at the same time it shows that systematic risk is can
not be diversified away.
The paper also, addressed the several approaches have been developed in order to
discount the future cash flow and the main advantages and disadvantages for each
model.
Finally, the paper shows the assessment of the investment required by the owner of
Lotus Blossom Bar Restaurant by calculating the net present value, which showed a
positive value and recommended to consider the investment.

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Introduction:
Over the past 25 years a serious disturbance have experienced in the financial markets
in many countries, and recently in 2008 another global financial crisis has occurred
associated with financial institutions difficulties and failures. Such risky events results
a severe disruption in the functioning of financial sector; the pricing of the financial
assets may be distorted; the clearing and settling of debts may be impaired, and price
shock, this disruption in the financial sector will be sever enough to lower aggregate
economic activities and damage the economy as a whole..
Such unexpected events have increased the concern about the systematic risk posed
by the financial sector in order to avoid the costly disruption in the functioning of the
financial sector of the economy.
The keystone in assessing the risk is to try to understand the relation between the
expected return and variance of the market portfolio, as according to Ghysels, Santa-
Clara, and Valkanov (2005) this relation is the “first fundamental law of finance.”
Such relation shows that the higher the risk the higher the return. And since there are
different types of investor such relation will motivate some investor to proceed for a
project, while it will be considered carefully by a cautious investor who prefers to be
very conservative.

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Types of Risk
In general, risk refers to the chance that some unfavourable event will happen . And
from financial point of view, the risk means that return will be lower than the
expected one.
There are two types of risk usually investor shall consider prior to any investment he
plans to place his money in: 1- unsystematic risk, and 2- systematic risk.
Unsystematic risk or unique risk is “the variability in the returns from holding shares
of a company resulting from factors unique to the company, such as the market in
which the firm sells its product, labour problems, and progress with R & D
programmes” (Module 4- university of Leicester, P 6.13). The effect of this type of
risk is limited to the firm, so it also calls firm-specific risk; for example a sudden
strike by employees of certain company can be unsystematic risk.
The unsystematic risk can be diversified by forming a portfolio of securities of
different industries, to counter balance any drop in certain company by another one
doing well in the same portfolio;
In general there are some resources of the unsystematic risk such as the “firm size, as
the smaller the firm the greater the risk, also, the factors related to the industry in
which the firm is performing, such as threat of new entrants, bargaining power of
customers, threat of substitutes, and rivalry” (website of The American Institute of
Certified Public Accountants - as on 14/04/09).
In 1952, Markowitz who demonstrated that diversification reduces the risk associated
with holding a portfolio of assets; he also derived precise relationship between
diversification and risk reduction, he showed that the key to understanding the
benefits of diversification lay in three major metrics: the weights employed in the
assignment of wealth individual portfolio components, the standard deviations of the
individual portfolio component, returns, and the pair-wise return correlation of the
various components of the portfolio.
Systematic risk or relevant risk (market risk): is the “ risk related to the variability in
returns stemming from macro-factors, both political and economic, which impact on
the fortunes of all firms, such as interest rate and exchange rate changes.” (Module 4-
university of Leicester, P 6.13); Campbell (1996) presents evidence that revisions in
forecasts of future labor income growth is a risk factor that helps price the cross-
section of stock returns. And since the systematic risk is associated with the aggregate

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market returns it can not be diversified within the market by forming portfolio of
securities of different industries; as it refers to the all securities.
Wars, raising inflation, and turbulent political events are examples for systematic risk.
Total Risk of the portfolio is the Standard deviation (volatility) of the portfolio returns
which expressed in the following equation
Total risk of portfolio = systematic risk + unsystematic risk

Measuring Risks
Risk usually measured by standard deviations of possible return.
As mentioned previously, investor concerned with reducing the unsystematic risk of
the securities by forming a portfolio of securities (a combined holding of more than
one stock, bonds, real estate, or any other asset) to mitigate or reduce the risk of single
security; as securities in one portfolio may not move together, so, if one security goes
down, others will go up and compensate for the loss of the first one.
Systematic risk for individual security can be measured using beta value; where beta
value reflects the extent to which return on security vary with the overall market
returns, in other word, Beta measures the stock’s volatility, the degree to which its
price fluctuates in relation to the overall market; in other words, beta measures the
responsiveness of security to movements in the market portfolio. This measure is
calculated using regression analysis, where a beta of 1 indicates that the security’s
price tends to move with the market, while a beta greater than 1 indicates that
security’s price tend to be more volatile than the market, for example beta of 1.2
means that security’s price will change by 1.2; in other word when market offers 10%
returns, the security will offer 12% return (in both direction).
Security which offers a return more than the market (in both directions) said to be an
aggressive stock, while security offers a return less than the market (in both
directions) said to be a defensive stock. These variations in stock returns in both the
directions are attributable to the systematic risk, in short, risk and return are positively
related which means that higher returns associated with higher risk.
Funding an investment in small and medium enterprises shall be based on expected
return commensurate with the risk of the investment. The most predominant model to
asses the price of an asset is the CAPM (Capital Asset Pricing Model). The general
idea behind CAPM is that investor needs to be compensated in two ways: time value

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of money and risk, the model is based on the premise that the equilibrium price of
risky asset may be derived from its expected return. The expected return compensates
the investor for the additional risk incurred above a minimum return on a risk free
asset.
According to CAPM, the expected return of a stock equals the risk-free rate plus the
portfolio's beta multiplied by the expected excess return of the market portfolio or
market risk premium, which expressed in the following equation:

ERj = Rf + βj (ERm – Rf)

Where: ERj is the expected return by investor on security j; Rf is the return on a risk
free asset; βj is the beta coefficient for security j; ERm is the expected return on the
overall market.
For example, a portfolio having βj =1.5, Rf = 3% and ERm= 10%, the expected return
will be as below:
ERj = 3% + 1.5 x (10% - 3%) = 13.5%
Considering the above and the fact that efficient markets does not offer a reward for
investor for bearing specific risk, in a well diversified portfolio, the total risk of
portfolio can be viewed as systematic risk; and hence the only risk considered to
assessing the required rate of return.

Although CAPM is the most predominant model in assessing an asset price, but there
are some criticisms of this model at the same time, for example, the model assumes
that the variance of returns is an adequate measurement of risk. This might be
justified under the assumption of normally distributed returns, but for general return
distributions other risk measures will likely reflect the investors' preferences more
adequately.

Also, CAPM model assumes that all investors have access to the same information
and agree about the risk and expected return of all assets (homogeneous expectations
assumption).

The model does not appear to adequately explain the variation in stock returns.
Empirical studies show that low beta stocks may offer higher returns than the model
would predict. (www.Answer.com)

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Discussion
In reference to the member of the board comments, the different ideas were all trying
to reduce the potential risk of holding specific stock or asset, and here it would be
wise to state that the keystone of reducing risk by owning some stocks is admittedly
quite contrary to the traditional admonishment, "Don't put all your eggs in one
basket”.
Generally, a rational investor would hold a market portfolio as in a well diversified
portfolio, unsystematic risk is very small, and consequently, the total risk of a
diversified portfolio is essentially equivalent to the systematic risk. Such comment
can be true in an efficient market and where the surplus to be invested is big enough
to form a large portfolio of securities of different industries, so that they spread their
money across a variety of sectors is a variety in performance. That is, each sector can
be expected to perform differently under a variety of market conditions thereby
offering the investor the possibility of extraordinary gains in one sector even if
another sector underperforms relative to the overall market. In this case they will be
having a well diversified portfolio of securities, where the unsystematic risk will be
eroded and reach an effective minimum, and the risk each security contributes to the
portfolio is approximately equal to its systematic risk or beta.

Being cautious investors unlike technical investors will be “very conservative and has
a need for financial security and will avoid high-risk ventures, preferring to conduct
their own financial affairs. They don't like to lose even small amounts of money and
never rush into investments, always giving financial opportunities a great deal of
thought”. (www.psychonomics.com) “as on April’15th 2009”.
A better solution for a cautious investor is to buy shares in one or more mutual funds,
as it has a major advantage is that it publishes tables showing exactly what returns or
result have been obtained by people who bought its shares on certain dates in the past;
Of course, the future is not guaranteed, but a fund's past performance record furnishes
a solid starting point.

A cautious investor must be aware about some factors in choosing the asset to be
invested in, which are: the diversification and its advantages, as with broad
diversification, a fund's past performance is a better guide to the future. Also, a
"balanced" mutual fund divides its assets among bonds or preferred stocks, or both, as

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well as common stocks. Naturally its market value per share fluctuates less than that
of a fund wholly invested in common stocks. Also, the type of common stocks owned
by a fund affects its volatility. So if a man gets panicky when the price of his stock
drops, he had better look for a balanced fund whose record shows a comparatively
stable price.

Cautious investors usually stand to make much smaller profits. As always,

diversifying a portfolio with a number of mutual funds.

Holding a stock with expected return less than the market as a whole, but not less than
the risk free rate, in this case the investor looking to be compensated for the time
bearing, and hence he preferred to hold stocks with low beta value, such situation is
advisable when the investor thought that the market going down. The market
portfolio

In general the best thing firm can do to invest in the stock market is to try to balance
the financial risk by holding a well-diversified mutual fund, as according to Roger
Gibson’s guidance in his book ‘Asset Allocation: Balancing Financial Risk,’” Holmes
says. “He suggests investing a maximum of 25 percent in resources and 25 percent in
international funds, and then rebalancing every year.”
(U.S. Global Investors’ Press Releases) http://www.usfunds.com/

Discounting Future Cash Flow (DCF)

Discounting future cash flow is one of the important economic theories of valuing an
investment in the 20th century. The notion of this concept is that money value is time
dependent, and it is always better to have money sooner rather than later, as £1
received on today worth more than £1 received after one year, because the earlier
received one can be invested and generate some earning; and hence, discounting cash
flow reflects a time value of money.
Future cash flow discounted in order to show the decrease in money value over time,
in other word it is converting future earnings to today’s money. For example an initial
cost or outlay is required to start a new business, and when the business started a cash
start to flow in, so, to know whether this cash have a greater value than the initial
investment and whether the future money worth in comparison with now, an investor

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would have to discount the future cash flow to the present value and compare it to the
initial investment. In other word by discounting cash flow a company value or project
under consideration as a whole can be determined properly.
Also, future cash flow discounted to compensate for the risk that the cash flow might
not materialize; the higher the risk the higher the discount rate; and hence, it is also
reflects the risk premium that represents the extra return which required by investor.
There are two major methods of cash discounting: the Net Present Value (NPV) and
Inter Rate of Return (IRR).
The NPV measures how much value is created or added by undertaking an
investment. Only investments with a positive NPV should be further considered for
investing.
A net present value (NPV) includes all cash flows including initial cash flows such as
the cost of purchasing an asset, whereas a present value does not.
The NPV calculated according to the below formula:
n CFt
NPV= Σ t - Iº
t=1 (1+r)
I
Where CFt is the cash flow in each year t; r is the required rate of return; and º is the
initial investment expenditure.

The other method used to discount cash flow is the internal rate of return (IRR)
The IRR defined as “the interest rate received for an investment consisting of
payments and income that occur at regular periods” (www.wikipedia.com), in other
word the IRR for an investment is the discount rate for which the total present value
of future cash flows equals the cost of the investment.
According to IRR the project can be considered to be invested in if the IRR value
exceeded the minimum required return. The IRR model contributes significantly on
the risk assessment by yielding the maximum discount rate which the project can
tolerate. Also, in contrast with NPV the cut-off rate in IRR can be used after the
calculation, such option helps in identifying the correct discount rate.
Although IRR is widely used approach in assessing projects but it still encountered
some problems in certain cases, for example it is like NPV can give conflicting

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answers in case of mutually exclusive projects, a multiple IRR problems can occurs
when cash flow during project lifetime is negative.

Lotus Blossom Bar and Restaurant Project

In assessing the project of upgrading the existing facilities of lotus Blossom Bar and
Restaurant, we recommend to calculate the net present value and make the final
decision based on the final result, so that the project can be consider to be invested in
if the NPV was positive.
Based on the above given formula the net present value will be as below:

Year 0 £100,000 £- 100,000 Initial outlay

Year 1 £10,000 £8929 NPV of cash inflow year 1
Year 2 £20,000 £15944 NPV of cash inflow year 2
Year 3 £40,000 £28471 NPV of cash inflow year 3
Year 4 £50,000 £31776 NPV of cash inflow year 4
Year 5 £30,000 £17023 NPV of cash inflow year 5
NPV £2142
As the NPV shows a positive value, we then the project can be undertaken and
considered investing into.

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Conclusion:
Although, the absence of an accurate measurement and the estimated value we can
still assume (based on many successful examples in the market) that contemporary
models of measuring all types of risk (systematic, unsystematic, and total) and also,
assessing the asset price are still very significant financial tools to aid an investor in
assessing any opportunity and making his final decision, such models are still
increasingly used by concern investors which is an evidence to its efficiency.
We can conclude that an investor must have minimum knowledge about concept used
in assessing any opportunity in order to aid his decision and avoiding spending his
money in a risky investment; while on the other hand If an asset is correctly priced,
the improvement in risk to return achieved by adding it to the market portfolio, will at
least equal the gains of spending that money on an increased stake in the market
portfolio.
Upon comparing the two different models of discounting cash flow (NPV and IRR)
we found that NPV model is considered the best in discounting cash flow because it
gives a clear signal in term of wealth creation ((Module 4- university of Leicester,
P.3.21). at the same time the IRR concept still an important criterion in evaluating or
comparing investments or purchases. And despite the disadvantages of both models
we can still consider both of them a very important financial tools in assessing any
project or investment.

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References:
Ghysels, E., P. Santa-Clara, and R. Valkanov, 2005, “There is a risk-return tradeoff
after all”, journal of Financial Economics, forthcoming.

Markowitz, Harry M. “portfolio Selection” 1952 Journal of Finance 7 (1), 77 - 89.

(University of Leicester, Finance and Growth Strategies –Module 4- MN7317/D, P
6.13)
http://www.aicpa.org/pubs/cpaltr/nov2000/supps/audit4.htm

Campbell, J. Y. (1996). Understanding risk and return, Journal of Political Economy

104(2): 298.

http://www.psychonomics.com/research/a&s/profiling.htm

University of Leicester, Finance and Growth Strategies –Module 4-MN7317/D, P3.21

http://www.usfunds.com/docs/press/viewpress.asp?recordid=63)

http://www.answers.com/topic/capital-asset-pricing-model

http://en.wikipedia.org/wiki/Internal_rate_of_return

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