Risk Management

Session 14
Risk Analysis in Business

Types of Investment risk

Depending on the nature of the investment, the
type of investment risk will vary.
Capital risk
Currency risk
Liquidity risk
Financial risk
Market risk

Capital Risk
A common concern with any investment is
that you may lose the money you invest your capital. This risk is therefore often
referred to as "capital risk."

Financial Risk
The risk that there may be a disruption in
the internal financial affairs of the
investment, thereby causing a loss of
value, is called "financial risk."

Liquidity Risk
Many forms of investment may not be
readily salable on the open market (e.g.
commercial property) or the market has a
small capacity and can therefore may take
time to sell. Assets that are easily sold are
termed liquid therefore this type of risk is
termed "liquidity risk."

Currency Risk
If the assets you invest in are held in
another currency there is a risk that
currency movements alone may affect the
value. This is referred to as "currency risk
."

Market Risk
The most familiar but often least understood
form of investment risk is "market risk."
The variability in a securitys returns resulting
from fluctuations in the aggregate market is
known as market risk.
All securities are exposed to market risk
including recessions, wars, structural changes in
the economy, tax law changes, even changes in
consumer preferences.
Market risk is sometimes used synonymously
with systematic risk.

inflation risk / purchasing power

risk
A factor affecting all securities is purchasing power
risk also known as inflation risk.
This is the chance that the purchasing power of
invested dollars will decline. With uncertain inflation,
the real (inflation-adjusted) return involves risk even if
the nominal return is safe (e.g., a Treasury bond).
This risk is related to interest rate risk, since interest
rates generally rise as inflation increases, because
lenders demand additional inflation premiums to
compensate for the loss of purchasing power.

Handling Risk
There are several approaches to handling risk:
(1) applying a discount rate commensurate with
the riskiness of the cash flows, and
(2) by using a certainty equivalent factor
(3) by evaluating the project using sensitivity and
breakeven analysis.
(4) by evaluating the project under simulated
cash flow and discount rate scenarios.

Using a Risky Discount Rate

The structure of the cash flow
discounting mechanism for risk is:Riskycashflow1 Riskycashflow2
NPV

...... InitialOutlay
1
2
(1 riskyrate )
(1 riskyrate )

The $ amount used for a risky cash flow is the

expected dollar value for that time period.

A risky rate is a discount rate calculated to

include a risk premium. This rate is known as
the RADR, the Risk Adjusted Discount Rate.

Defining a
Risky Discount Rate

1.
2.
3.

Conceptually, a risky discount rate, k, has

three components:A risk-free rate (r), to account for the time
value of money
An average risk premium (u), to account for
the firms business risk
An additional risk factor (a) , with a positive,
zero, or negative value, to account for the
risk differential between the projects risk
and the firms business risk.

Calculating a
Risky Discount Rate
A risky discount rate is conceptually defined
as:
k=r+u+a
Unfortunately, k, is not easy to estimate.
Two approaches to this problem are:
1. Use the firms overall Weighted Average Cost of
Capital, after tax, as k . The WACC is the overall rate
of return required to satisfy all suppliers of capital.
2. A rate estimating (r + u) is obtained from the

Capital Asset Pricing Model, and then a is added.

Calculating the WACC

Assume a firm has a capital structure of:
50% common stock, 10% preferred stock,
40% long term debt.

Rates of return required by the holders of each are :

common, 10%; preferred, 8%; pre-tax debt, 7%.
The firms income tax rate is 30%.
WACC = (0.5 x 0.10) + (0.10 x 0.08) +
(0.40 x (0.07x (1-0.30)))
= 7.76% pa, after tax.

The Capital Asset Pricing

Model
This model establishes the covariance
between market returns and returns on
a single security.
The covariance measure can be used
to establish the risky rate of return, r,
for a particular security, given expected
market returns and the expected risk
free rate.

CAPM Model
The expected return (%) = risk-free return (%) +
sensitivity to market risk * (historical return (%)
- risk-free return (%))
Put another way
the expected rate of return (%) = the yield on
the treasury note closest to the term of your
project + the beta of your project or security *
(the market risk premium)
the market risk premium has historically been
between 3-5%

Calculating r from the CAPM

The equation to calculate r, for a
security with a calculated Beta is:

r is the required rate of

Where : E ~
return being calculated, R f is the risk free
rate: is the Beta of the security, and Rm
is the expected return on the market.

Beta
Beta is a relative measure of risk-the risk of an
individual stock relative to the market portfolio
of all stocks.
Beta measures a security's volatility, or
fluctuations in price, relative to a benchmark,
the market portfolio of all stocks.
Stocks with high betas are said to be high-risk
securities.

The Regression Process

The value of Beta can be estimated as the regression coefficient
of a simple regression model. The regression coefficient a
represents the intercept on the y-axis, and b represents Beta,
the slope of the regression line.

rit a bi rmt u it

Where,

rit = rate of return on individual firm is shares at time t

rmt = rate of return on market portfolio at time t
uit = random error term (as defined in regression
analysis)

Key Points (model)

The models states that investors will expect a
return that is the risk-free return plus the
security's sensitivity to market risk times the
market risk premium.
The risk free rate is taken from the lowest yielding
bonds in the particular market, such as
government bonds.
The risk premium varies over time and place, but
in some developed countries during the
twentieth century it has averaged around 5%.
The equity market real capital gain return has been
about the same as annual real GDP growth

The Certainty Equivalent Method:

Adjusting the cash flows to their certain
equivalents.

The Certainty Equivalent method adjusts the

cash flows for risk, and then discounts these
certain cash flows at the risk free rate.

CF1 b CF2 b
NPV

etc CO
1
2
1 r
1 r
Where: b is the certainty coefficient (established by
management, and is between 0 and 1); and ris the
risk free rate.

Important Factors
Important factors in risk measurement
Volatility
variance or standard deviation
Beta

Volatility
Volatility may be described as the range of
movement (or price fluctuation) from the
expected level of return.
The more a stock, for example, goes up and
down in price, the more volatile that stock is.
Because wide price swings create more
uncertainty of an eventual outcome, increased
volatility can be equated with increased risk

Variance or standard deviation

This is a measure of the spread or
dispersion in the probability distribution;
that is, a measurement of the dispersion of
a random variable around its mean.
The larger this dispersion, the larger the
variance or standard deviation.
The larger the standard deviation, the
more uncertain the outcome.

What does risk mean in capital

budgeting?

Risk relates to uncertainty about a

projects future profitability.
Measured by ?NPV, ?IRR, beta.

Is risk analysis based on historical data

or subjective judgment?

Can sometimes use historical data, but

generally cannot.
So risk analysis in capital budgeting is
usually based on subjective judgments.

What three types of risk are relevant

in capital budgeting?
Stand-alone risk
Corporate risk
Market risk

How is each type of risk measured, and

how do they relate to one another?
1. Stand-Alone Risk:
The projects risk if it were the firms only
asset and there were no share-holders.
Ignores both firm and shareholder
diversification.
Measured by the ? or CV of NPV, IRR, or
MIRR

Stand-Alone Risk

2. Corporate Risk
Reflects the projects effect on corporate
earnings stability.
Considers firms other assets
(diversification within firm).
Depends on:
projects , and
its correlation with returns on firms other
assets.

Measured by the projects corporate beta

versus total corporate earnings.

3. Market Risk:

Reflects the projects effect on a welldiversified stock portfolio.

Takes account of stockholders other
assets.
Depends on projects ? and correlation
with the stock market.
Measured by the projects market beta.

How is each type of risk used?

Market risk is theoretically best in most
situations.
However, creditors, customers, suppliers,
and employees are more affected by
corporate risk.
Therefore, corporate risk is also relevant.

How is each type of risk used

Stand-alone risk is easiest to measure,
more intuitive.
Core projects are highly correlated with
other assets, so stand-alone risk
generally reflects corporate risk.
If the project is highly correlated with
the economy, stand-alone risk also
reflects market risk.

What is sensitivity analysis?

Shows how changes in a variable such
as unit sales affect NPV or IRR.
Each variable is fixed except one.
Change this one variable to see the
effect on NPV or IRR.
Answers what if questions, e.g.
What if sales decline by 30%?

Results of Sensitivity Analysis

Steeper sensitivity lines show greater
risk. Small changes result in large
declines in NPV.
Unit sales line is steeper than salvage
value or k, so NPV is more sensitive to
changes in unit sales than in salvage
value or k.

What are the weaknesses of

sensitivity analysis?
Does not reflect diversification.
Says nothing about the likelihood of
change in a variable, i.e., a steep sales
line is not a problem if sales wont fall.
Ignores relationships among variables.

Why is sensitivity analysis useful?

Gives some idea of stand-alone risk.
Identifies dangerous variables.
Gives some breakeven information.