Risk and Rates of Return
1
Module 3
Filmore Enterprises
Directed
Kathy Filgrade started Computer
Products Corporation (CPC) in 1985 to design computer systems for individuals
and small offices. The company produces machines and software to fit unique
customer needs and sells the systems at reasonable prices. The company started
small and put a heavy emphasis on customer service and education. Many of the
initial customers were computer illiterate and appreciated the staffâs
willingness to explain the capabilities of computing in a direct and
non-intimidating manner. Customers felt that the technicians could configure
systems to meet their requirements and then provide the necessary instructions
to operate them efficiently. As a result, customers developed a special
relationship with the company and continue to patronize the store with subsequent
computer and software requirements.
CPCâs reputation for quality and for friendly, knowledgeable
employees allowed the company to expand rapidly. By March 1997 the company
operated six âmega-storesâ between Chicago and Milwaukee. The company is
operating smoothly, and Kathy is interested in pursuing additional business
opportunities. She does not want to open stores too far from her office because
she feels the existing regional focus provides strong quality control. She also
believes that the current geographic market area is saturated with computer
stores. Therefore, she is interested in identifying a related line of business
in which to operate.
Kathy is aware of the growing demand for cyber-bars or
cyber-cafes that are springing up throughout the country. These establishments
provide ready access to computing resources, including the internet, in a
relaxed atmosphere. They allow traveling business professionals, stuÂdents, and
others a place to work and socialize. Kathy believes that she can provide a
competitive edge to this type of operation by offering on-site computer
consultation. She is comfortable with the hardware and software demands of this
type of enterprise and can hire excellent consultants and instructors from her
existing stores. However, she is interested in finding a partner to handle the
food and beverage aspect of the business.
While attending the board of trustees meeting for the local
community college, Kathy mentioned her idea to another trustee, Randy Morely.
Randy owns and operates Morely Distributors, the local beverage company that he
inherited from his father. He has worked at Morely Distributors since
graduation from college and assumed full responsibility for the business ten
years ago. Randy is an excellent businessman. He had worked with Kathy
previously to develop a management information system for his operation, which
resulted in a general reorganization of the business. Those changes were
instrumental in doubling the companyâs profitÂability. In spite of this success,
Randy feels he operates in his fatherâs shadow.
Randyâs prior association with Kathy was extremely positive. They
worked well together even though they approached issues from different points
of view. Their distinct perspectives helped avoid problems with the new system
and strengthened the final project. He is very impressed with the quality of
Kathyâs operation, and he thinks that the cyber-cafe would provide a perfect
joint venture in which to develop his own business repuÂtaÂtion. Randy also
believes that the local business environment is perfect for establishing this
type of endeavor and that the business has great profit potential.
Due to his sales contacts, Randy is well connected with the
restauÂrant industry. He is aware of a small chain of successful delicatessens
that could be bought and expanded to include a computer area. He also knows
several excellent restaurant managers who may be interested in running the food
and beverage part of the operation.
Kathy and Randy decided to pursue the development of a cyber-cafe
and name it Filmore Enterprises in order to provide additional room for
diversification. They hired a consulting company to conduct a feasibility
study. The study determined that strong local demand for this type of service
exists, but start-up costs are high. In spite of the initial costs, breakeven
is anticipated in three years, and the profit potential is excellent.
After the company establishes a solid track record, Kathy and
Randy want to take Filmore Enterprises public, through an initial public
offering that would trade over the counter. They know that most people are risk
adverse and require a higher return for holding riskier investments. They are
interested in understanding these issues more fully. Therefore, they asked the
consultants to prepare a discussion of risk and return. Since Kathy and Randyâs
current wealth is tied up in their individual companies, they want the
discussion to start with a formal explanation of the risk-and-return
relationship relative to ownership in a single company. They want the
explanation expanded to include risk and return issues important to potential
investors who hold a portfolio of stocks. Finally, they are interested in
understanding the risk of managerial decisions as opposed to investorsâ
decisions and how investorsâ perceptions affect the âtrue riskâ of corporate
decisions.
To help make the discussion more concrete, the consultants conÂtacted
and obtained forecast data from several major brokerage companies with which
they had a close working relationship. Because of forecast uncertainty, the
consultants developed security returns for five scenarios with corresponding
probabilities of occurrence for the financial instruments listed in Table 1.
Specifically, the table lists data for short-term and long-term treasuries,
publicly traded stocks for a regional restaurant chain (referred to as EAT),
two companies with operations similar to CPC and Morely, and an index fund
designed to mirror the performance of small stocks as represented by the
NASDAQ. The statistical properties for CPC were left incomplete so that they
could be used for learning tools during the discussion. The consultants also
developed partial data on portfolios composed of CPC-Morely, CPC-EAT, and
Morely-EAT in order to explain how diversification helps investors and why it
is important for determining investorsâ required return. The consultantsâ
research indicated that Filmore Enterprises should be similar to a company
comprised of 40% computer and 60% restaurant business. The portfolio data for
such a company is included in Table 2.
As an employee of the consultant company, you have been assigned
to develop and lead the meeting with Kathy and Randy. To help prepare for the
meeting, you have been provided the following questions.
Table 1
Returns on Alternative Investments
Estimated Rates
of Return
Long‑Run State
of the Economy
Prob.
T‑Bills
T‑Bonds
CPC
MORELY
EAT
NASDAQ Index
Recession
0.10
4.5%
10.0%
â18.00%
18.00%
â13.00%
â13.00%
Below avg.
0.20
4.5
7.0
â8.00
14.00
â6.00
â2.00
Average
0.40
4.5
5.0
11.00
6.00
10.00
11.00
Above avg.
0.20
4.5
3.0
26.00
â1.00
20.00
17.00
Boom
0.10
4.5
2.0
35.00
â11.00
30.00
22.00
Expected return
Variance
0.0
5.0
65.8
161.9
103.4
Std deviation
0.00%
2.23%
8.11%
12.72%
10.17%
Coef of var (CV)
0.00
0.43
1.42
1.50
1.23
Beta coefficient
0.00
â0.22
1.53
â0.77
1.22
1.00
1. Expected returns on stocks consist of an expected dividend yield
plus an expected capital gains yield. The dividend yield is relatively preÂdictable,
but the capital gains yield is uncertain. Therefore, most of the variation
between the high and the low returns shown in the table result from uncertainty
about the stocksâ prices and the resulting capital gains or losses.
2. Returns on T-bonds during a given year consist of interest income
plus capital gains if bond prices rise, or capital losses if prices decline. An
increase in interest rates will lead to falling bond prices, while a deÂcline
in rates will lead to rising bond prices. Interest rates tend to rise during
recession and fall during booms.
3. Betas are most appropriate for stocks. They are questionable for
long-term bonds, primarily because bond returns are not included in the market
index.
Table 2
Returns on Portfolios
Portfolio
Long-Run State of the
Economy
Prob.
50% CPC 50% Morely
40% CPC 60% EAT
50% Morely 50% EAT
Recession
0.10
â15.00%
2.50%
Below avg.
0.20
â6.80
4.00
Average
0.40
10.40
8.00
Above avg.
0.20
22.40
9.50
Boom
0.10
32.00
9.50
Expected return
8.98%
7.10%
Variance
197.1
6.1
Std deviation
14.04%
2.47%
Coef of var (CV)
1.56
0.35
Questions
1. Calculate the expected rate of return for each of the financial
assets listed in Table 1, and complete the expected return row for Table 1.
Based solely on the expected returns, which of the investments appears the best
and worst? Discuss the impact on returns for general changes in the economy for
CPC, Morely, and EAT.
2. Considering U.S. Treasuries are guaranteed by the U.S. government,
answer the following questions.
a. Is the T‑bill return independent of the state
of the economy? Briefly explain. Do T‑bills promise completely risk‑free
returns? Explain.
b. Why do T‑bond returns vary? Why are T‑bond
returns high when the market returns are low?
c. How would returns on corporate bonds that
Filmore Enterprises might issue compare with those for T-bonds? Would your
answer be dependent on the potential bond rating of Filmore Enterprises?
3. Basing a decision solely on expected returns is appropriate only for
risk-neutral individuals. Since most people are risk averse, risk is an
important consideration for the decision.
a. Two possible measures of risk are the standard
deviaÂtion and the coefficient of variation. Calculate the standard deviation
and coefficient of variation for CPC returns and complete the related blanks in
Table 1.
b. Compare the risk and expected return
relationships among all six assets listed in Table 1. Explain the apparent
discrepancies with the normal risk and return tradeoff.
4. Suppose investors create a 2‑stock portfolio by investing $100,000
in CPC and $100,000 in Morely.
a. Calculate the expected return for each state
of the economy, and then compute the expected return for the portfolio.
Complete the related blank in Table 2.
b. Compute the standard deviation for the portfolio,
and compare it to the standard deviation of the individual stocks. Complete the
related blanks in Table 2.
c. In general, how would risk be affected if you
formed another portÂfolio composed of CPC and EAT? Explain how the correlation
coefÂficient affects the level of diversification in the CPC-Morely and the
CPC-EAT portfolios.
d. Explain what would happen to the expected
return and standard deviation as the portfolio mix changes. If you are using
the spreadÂsheet model for the case, determine the expected return and standÂard
deviation for a series of CPC-Morely portfolios starting with 0% CPC and
increasing the percentage by 10 points for each iteration.
5. Suppose an investor has a portfolio consisting of just one
randomly-selected stock. What happens to the risk as the investor adds more and
more randomly-selected stocks to the portfolio? Illustrate your answer with a
graph showing âportfolio standard deviationâ on the vertical axis and ânumber
of stocksâ on the horizontal axis.
6. Answer the following
questions relating to diversification.
a. What implication does diversification have for
investors?
b. If an investor decides to hold a 1-stock
portfolio and as a result is exposed to more risk than diversified investors,
could the non-diversified investor expect to be compensated for all his or her
risk? That is, could the investor earn a risk premium large enough to compenÂsate
for that part of the total risk that diversification could have eliminated?
c. Explain the difference between total risk,
diversifiable risk, and market risk.
d. How might the desire for diversification of
individual retirement funds affect the structure of U.S. investments?
7. Change Table 1 by substituting Year 1 through Year 5 for the states
of the economy.
a. Plot the characteristic lines for CPC, Morely,
and T-bills showing the returns on the index (the market) on the X-axis and the
returns on the asset on the Y-axis. Estimate (by visual inspection) the slope
for each line. If you are using the spreadsheet model, compute the slope
coefficients. How do these compare to the betas provided in Table 1?
b. What is the significance of the distance
between the plot points and the regression line, that is, the errors?
c. What do betas measure, and how are they used in
risk analysis?
d. Develop a chart depicting the beta and
expected return for each security, determined from the data provided by the
investment bankers. Does the risk and return relationship appear reasonable
relative to the market?
8. Using T-bonds as a risk-free rate and the NASDAQ index as the
market,
a. Plot the Security Market Line (SML).
b. Calculate the required rate of return for CPC,
Morely, and EAT based on the Security Market Line. Compare the required return
from the SML with the expected return from Question 1. Explain the decision to
either buy or sell each of the stocks, given this information.
c. Are the stocks in equilibrium? If not, how
would equilibrium be restored?
9. Filmore Enterprises is expected to be similar to a company composed
of 40% CPC and 60% EAT.
a. Compute the beta coefficient for a 40/60
portfolio of CPC‑EAT and then determine its required rate of return. How does
the required return compare with the expected return from Table 2? Explain why
you would or would not purchase this portfolio.
b. Suppose Kathy and Randy decided to provide a
greater share of the up-front capital so that the long-term debt ratio was
below that represented by the CPC-EAT portfolio. What impact would this have on
Filmore Enterprisesâ risk and required return on equity?
10. The SML might shift in response to various economic changes. A
change in the SML affects security prices and rates of return.
a. Suppose investors raised their expectations
for inflation by 4 percentage points over current estimates as reflected in the
5.2% T‑bond rate. Explain the effect this would have on the SML and on the
returns required on high- versus low-risk securities.
b. Disregard Question 10a and assume that
investorsâ risk aversion increased enough to cause the market risk premium to
rise by 4 percentage points. Explain what effect this would have on the SML and
on returns of high-risk versus low-risk securities.
c. Discuss the kinds of changes Questions 10a and
10b would have on short-run and long-run effects; for example, might an
increase in expected inflaÂtion lead to lower returns in the short run followed
by higher returns in the long run?
11. Rather than focusing on risk from an investorsâ decision-making perÂspective,
consider the risk of corporate decisions and how investorsâ perceptions affect
the âtrue riskâ of corporate decisions.
a. Why is it important for operating managers to
be cognizant of the way investors look at risk?
b. Suppose a particular decision appears
particularly risky to investors (for instance, it would make the firm look
risky), but the firmâs managers, who know more about the situation than
investors, think the decision is really not very risky. How might this
situation affect the decision to accept a particular project based on each of
the following factors?
(1) The
project can be financed with internal funds; therefore, the firm does not need
to sell securities to undertake the project.
(2) The
project is very large, and securities must be sold to finance it.
(3) The
project is long-term; therefore, it will take years for the company to complete
the project and begin receiving cash flows.
(4) The
project is short-term, so the company can complete it and receive cash flows
within a few months.
c. How would your answers to Question 11b change
if the project appeared safe to investors, but the company managers knew that
it was quite risky?
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