Chapter 13 – Risk from the Company Perspective prospective

Chapter 13 –
Risk from the Company Perspective
Reasons for looking at risk from the company
 The
company perspective is often the focus of senior
 Customers who depend on company survival to support
the product will consider company perspective
 Other stakeholders such as employees, suppliers, lenders,
and communities, will consider total company risk
 Security analysts typically follow one or a few industries
and are responsible for making successful picks
Correlation and Company Risk
Correlation between project and firm
 Capital
budgeting does not start with a clean slate
 The firm is a portfolio of projects
 The risk question for capital budgeting is the impact of
a new project on the overall risk of the firm’s when
combined with the existing portfolio of projects.
Mean-variance Portfolio Measures
Holding period return =
Ending value – Beginning value + cash flow
Beginning value
 Covariance (A,B)
=  pi[RA,i - E(RA)][RB,i - E(RB)]
 Correlation (rA,B) = A,B/(AB)
Beta (A,B) = A,B/B2
Interpretation of Risk Measures
Covariance is mathematically important for
portfolio construction, but does not have a simple
 Correlation measures the proportion of variance in
returns explained by covariance.
 +1
or -1: if we know the return on asset B, we can
predict the return on A with perfect accuracy.
 0: knowing the return on asset B is of no help in
predicting return on asset A
Interpretation of Risk Measures: Beta
A beta of 2 says that if return on B rises 10%, we
expect return on A to rise 20%.
 A negative beta says returns move in opposite
 Correlation measures the strength of that
relationship. A beta of 2 and correlation of .01 says
that while we expect A to rise 20% on average if B
rises 10%, the relationship is so weak as to be of
little use in practical predictions.
Two-asset Portfolio
Expected return (E(Rp))
= E(Rp) = WAE(RA) + WBE(RB)
Standard deviation
p =  WA2A2 + WB2 B2 + 2 WAWBA,B
Contribution to Company Performance
A new capital investment will improve the
company’s reward to risk ratio if
[E(RA) – Rf]/ A,C > [E(RC) – Rf]
E(RA) = Expected return on the asset
= risk-free rate
A,C = beta of the asset in relation to the company’s
existing portfolio of investments
E(Rc) = Expected return on the company’s existing
portfolio of assets
Problems in Applying Mean-variance
Model to Capital Budgeting
Indivisibility of assets
 Holding period choice problem
 Defining borrowing-lending rates
 Data needs
Other Selection Techinques
Skewness-based models
 Growth-optimal (geometric mean) model
 State-preference models
Sensitivity-related Company Portfolio
Risk Analysis
Develop financial planning model
 Model the company under various economic
 With
the proposed project
 Without the proposed project
Use measures such as
 Cash
 Return on equity