FINANCE (Midterm)

Risk management - is the process of measuring or assessing risk and developing

strategies to manage it.

Importance of risk management:

 Risk management is important because it tells businesses about the threats in
their operating environment and allows them to preemptively mitigate risks. In
the absence of risk management, businesses would face heavy losses because
they would be blindsided by risk.

5 steps of the risk management process: 5 basic methods for risk management:
1. Identify the risk 1. Avoidance
2. Analyze the risk 2. Reduction
3. Evaluate or rank the risk 3. Sharing
4. Treat the risk 4. Retention
5. Monitor and review the risk

Common risks in finance:

1. Business risk - refers to the uncertainty about the rate of return caused by the
nature of the business.
2. Financial risk - is the possibility of losing money on an investment or business
venture.
3. Liquidity risk - is associated with the uncertainty created by the inability to sell the
investment quickly to cash.
4. Default risk - the risk that a lender takes on in the chance that a borrower will be
unable to make the required payments on their debt obligation.
5. Interest risk - risk that changes in interest rates may reduce the market value of
the bond you hold.
6. Management risk - decisions made by a firms management and BOD materially
affect the risk faced by the investors.
7. Purchasing power risk - possibility that you will not be able to buy as much with
your savings in the future.
8. Investment risk

Commonly used techniques and models assessing investment alternatives under risk:
1. Probability - the likelihood of an event occurring and the consequences, to which
extent the project is affected by an event. Range anywhere from just above 0% to
just below 100%. (1 is certain, 0 is not risk).
2. Value of information - the company may decide to hire marketing analyst to
obtain additional information on the environmental situation.
3. Sensitivity analysis - “what if analysis” is a financial model that determines how
target variables are affected based on changes in other variables known as input
variables.
4. Simulation - is a mathematical model that calculates the impact of uncertain
inputs and decisions we make on outcomes that we care about, such as profit and
loss, investment returns, etc.
5. Decision tree - diagram that shows the several decisions or acts and the possible
consequences called events of each act.
6. Standard deviation and coefficient of variation
7. Project beta - is a measure of systematic or market risk present in a particular
project.

Estimating risk and return on assets

Risk - return relationship: “The higher the risk the higher the return.”

Return - total gain or loss experienced in an investment over a given period of time.

Portfolio return - refers to the gain or loss realized by an investment portfolio

containing several types of investments.

Portfolio vs. Single asset

 An asset held in a portfolio is less risky than the same asset held in isolation.
 The fact that a particular stock goes up and down is not very important - what is
important is the return on the investor’s portfolio, and the risk of that portfolio.

Example:
(single asset)
Total investment: 1,000,000
Stock A: 1,000,000 investment and an expected return of 15%.

(Portfolio)
Stock A: 500,000 invested and an expected return of 15%.
Stock B: 200,000 invested and an expected return of 6%.
Stock C: 300,000 invested and an expected return of 9%.

Risk preference:
1. Risk-averse
2. Risk-indifferent
3. Risk-seeking

Types of risk
Systematic risk Unsystematic risk
 Currency risk  Principal risk
 Equity risk  Credit risk
 Inflation risk  Liquidity risk
 Interest rate risk  Call risk

Diversification - technique that reduces risk by allocating investments across various

financial industries. It aims to maximize returns by investing in different areas that
would each react differently to the same event. It is best to have a negative
correlation.
Probability distribution - yields he possible outcomes for any random event.

Expected return: (determine the return)

State of the Probability Return A Expected Return B Expected

economy rate of rate of
return (A) return (B)
Good .3% 100% 30% 20% 6%
Average .4% 15% 6% 15% 6%
Bad .3% -70% -21% 10% 3%

For return A: For return B:

.30x.100 = 30 .30x.20 = 6
.40x..15 = 6 .40x.15 = 6
.30x-.70 = -.21 .30x.10 = 3
15% expected return 15% expected return

Standard deviation: (determine the risk)

(k) is expected return
(Pi) is probability
For return A:
Ki - k (Ki - k)2 (Ki - k)2 Pi
.1-.15 = .85 .7225 .21675
.15-.15 = 0 0 0
-.70-.15 = -.85 .7225 .21675
1.445 return .4335 or 43.35% variance

SD = √.4335 = 65.84% CV= 0.6584/1.445 = 0.4556

Portfolio return using CAPM

What is the Capital Asset Pricing Model(CAPM)?

 It is a model that describes the relationship between the expected return and
risk of investing in a security.
Formula:
r = rf + b(rm - rf)

Where:
R = the required rate of return
Rf = the risk-free rate
Rm = expected rate of return of the market
B = volatility of the asset in relation to the market as a whole
COST OF CAPITAL

Capital structure - the mix of the long term sources of funds used by the firm.

Objective: To maximize the market value of the firm thru an appropriate mix of long
term sources of funds.
Composition:
1) Long term/non-current debt
2) Preferred shareholder’s equity
3) Ordinary shareholder’s equity

Optimal capital structure - mix of long term sources of funds that will minimize the
firm’s overall cost of capital.

Cost of capital - the cost of using funds. “weighted average rate of return” .
minimum required rate of return of an investment t avoid impairment in the
shareholders value.
Components:
1) Cost of debt
2) Cost of PS
3) Cost of OS
4) Cost of RE

Computation of cost of capital:

SOURCE CAPITAL COST OF CAPITAL
Creditors Long-term debt After tax rate of interest
N= ER (1-tax rate)
Stockholders:
Preferred Preferred stock Preferred dividends per
share
N = dividends/ net
proceeds
Common Common stock Earnings per share
(CAPM approach)

Expected returns by the providers of capital:

1) Creditors - interest
2) PS holders - dividends
3) OS holders - dividends and growth
LONG TERM FINANCING

Sources of funds
External sources: Debts, Equity and Internal sources: Retained earnings
Hybrid

Debt financing: Equity financing: Hybrid financing:

 Loans  Ordinary shares  Preferred shares
 Bonds  Retained earnings  Leasing
 Options securities

Debt financing

Term loans - have maturities of more than 1 t 10 years, repaid in periodic

installments over the life of the loan and secured by a chattel mortgage.

Bonds - corporation will borrow money from investors. In exchange with he money
borrowed, the corporation will issue bond certificate. The borrowing corporation will
pay interest to the investors. This is the cost of borrowing thru bonds. At a maturity
date, the principal will be returned to the investors.

Current yield - ratio of the annual interest payment to the bond’s market price.
Yield to maturity - bonds internal rate return . Effective rate. Fluctuates.
Coupon rate - rate stated on the bond certificate. Fixed.
YTM > Coupon rate = Discount
YTM < Coupon rate = Premium

Equity financing

Ordinary share - represents ownership interest of the firm.

Valuation of stocks
Based on holding period:
1) Finite period dividend valuation - investor plan to purchase an ordinary equity
share and hold it for a specific length of time.
2) Infinite period dividend valuation - investor plan to purchase an ordinary equity
share and hold it indefinitely.
Based on Dividend growth rate:
3) Zero growth dividend model - assumes dividends remain a fixed amount over
time.
4) Gordon constant growth dividend model - assumes that dividends grow at a
constant rate each period.
5) Supernormal growth model - assumes that dividends grow at an above normal
rate over some time period and then grow at a normal rate thereafter.
Retained earnings - earnings after deducting interest, taxes, and preferred dividends
may be retained and used to pay common cash dividends or be flowed back into the
firm in the firm in the form of additional capital investment through stock dividends.

Hybrid financing - combination of debt and equity financing.

Preferred shares - priority to assets and earnings rather than common shareholders.
Always have par value, mostly provide cumulative dividends and some are
convertible to common stock.

Valuation of Preferred shares

Po = Dp
Kp

Where: Dp = per share cash dividend

Kp = Investors required rate of return

Leasing - a rental agreement that typically requires a series of fixed payments that
extend over several periods.

Option securities
1) Option - created by outsiders rather than the firm itself, it is a contract that
gives its holders the right to buy or sell stocks at some predetermined price
within a specified period of time.
2) Warrant - an option granted by the corporation to purchase a specified number
of shares of common stock at a stated price exercisable until sometime in the
future.

SOLVING CAPM

1. r = rf + b (rm - rf) [ rm? ]

11.75% = 4.3% + 1.23 (? - 4.3)
11.75/4.3
7.45 = 1.23 (? -4.3)
7.45 = 1.23x4.3
7.45=1.23 rm - 5.289
7.45 + 5.289 / 1.23
Rm = 10.36%

2. r = rf + b (rm - rf) [(rm - rf)] = Rpm or market risk premium

12.25 = 5 + 1.15 Rpm
12.25 - 5 / 1.15
Rpm = 6.30%
3. r = rf + b (rm - rf) [ rf? ]
Rf = rrf + IP
Where,
Rrf = real risk-free rate
IP = inflation percentage

4. Percentage change in the return on the stock

R = 15%
Rm = 10% increase by 30%
Rf = remain unchanged

r = rf + b (rm - rf)
15 = rf + 2 (10 - rf)
15 = rf + 20 - 2 rf
Rf = 5%