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Analysis
Fears in business operations are known as risks. They mainly affect external and international
relations and other business relations. In the event where operational risks are prominent, the
viability of a business in the future deteriorates and is a complete failure or crippling of the entire
business system. Risk aversion also takes into consideration proper analysis of future prospect of
a specific business before even making an ideal analysis of future prospect of a specific business
before engaging in capital investment (Denne & Cleland-Huang, 2004, p. 114).
Additionally, understanding the amount of returns a person would expected from capital invested
under a risky business environ is very crucial. This needs accurate quantitative risk measures in a
way that allows investors to make the right investment decisions.
1) Discuss the concept of stand-alone or project risk and distinguish this risk and its measure
from portfolio risks
Standalone risk is a term in portfolio management. Under risk evaluation and management, risk
diversification would ensure proximity towards the aversion. In this kind of risk, the interest of
top leadership would help to ensure that undiversified personal risk within the complete portfolio
(Denne & Cleland-Huang, 2004, p. 129). Project managers under the stand alone risk are able to
determine risks associated with a specific project as an individual entity.
Whereas the standalone risk if often a measure of the standard nonconformity of anticipated
returns, variance co-efficiency of expected return, portfolio risk is still a measure of beta
coefficient. One is therefore able to judge the suitability of a specific project portfolio.
2) Using the information given in exhibit 1, determine the most likely rate of return for each
investment in the upcoming period. In addition, find the standard deviation of return for each
investment.
Workings
Assuming that all the four incidences have equal opportunities of influencing return levels within
the three industries, the probability (Pi) would be 25 percent for I=1, 2, 3 and 4
Hence, E(R)
Where E(R) = the predictable return on the store
N= the number of situations
Pi = the likelihood of scenario i
Ri = the return on the stock in state i
E (Rw) for Waxell Inc. = 0.25(-2.00%) +0.25(6.75%) + 0.25(9.21%) + 0.25(14.50%)
(Rw) = -0.5 + 1.6875 + 2.3025 + 3.625 = 7.115%
E (Rs) for Stewart Inc. = 0.25(2.54%) + 0.25(4.35%) + 0.25(6.78%) + 0.25(9.71%)
E (Rs) = 0.635 + 1.0875 + 1.695 + 2.4275 = 5.845%
E(RE) for Edelman Inc. = 0.25(15.46%) + 0.25(7.50%) + 0.25(4.60%) + 0.25(1.54%)
E (RE) = 3.91 + 1.875 + 1.15 + 0.385 = 7.32%
From the calculations above, Edelman Inc. has the uppermost expected rate of return.
audit to help counteract diverse effects of related risks. Today, many businesses use Capital
Asset Pricing Model (CAPM) or Security Market Line (SML) to measure a companys risk
premium (Friend, Bicksler, American Telephone and Telegraph Company and Conference on
Risk and Rate of Return, 1977, p. 323).
Risk premium is the difference between investment (asset) return and risk free return. This is to
say, Risk Premium = Ra Rf, where Ra and Rf are asset and risk free returns respectively. The
formula tries to investigate the amount that a stockholder is likely to get as reward from a
venture that faces various risks.
In regards to calculation of risk premium, the CAPM formula utilizes beta coefficient to
calculate the risk premium of a specific investment. With CAPM in mind, the formula for risk
premium would be as bellow.
Risk premium = (Rf + (Rm -Rf)) Rf where Rf is the risk free return, is the beta constant and
Rm is the marketplace rate of return. For instance, given that the value of beta is 1.08, the market
rate of return is 8 percent and risk free rate is 4 percent. One may also calculate risk premium as
follows using the CAPM
Risk premium = Ra Rf
But Ra = Rf + (Rm Rf) = 0.04 + 1.08(0.08- 0.04) = 0.0832 = 8.32%
Hence, Risk Premium = 0.0832 0.04 = 0.0432 = 4.32%
On the other hand, a person can also measure premium risk using the SML method. The SML
method becomes quite easy to evaluate and understand when one uses the graphical approach as
below (Douglas, 1988, p. 201).
It would also be convenient to know that the SML slope is the market risk premium and it can be
calculated as Risk Premium = (E[Rm] Rf). Most importantly, a risk averse investor should be
able to interpret the y-intercept of the SML as it is Risk Free rate.
Conclusion
The main reason as to why people make investments in different businesses is to realize high
returns at the end of an accounting period. Investors make investments if they conclude that their
investments can grow to a level of capturing high returns in the long run. Businesses also operate
in uncertain future full of fears. Such fears are constraints that make stockholders shun away
from making contributions via financial engagement and in a way that will help the business to
grow.
When it comes to performance of the business, the viability of future operation strategies depend
on the fact that the management are able to evaluate the future prospect of the business through
policy makers. Therefore, it calls for ideal financial audit as well as planning in light to
anticipated returns and possible constraints.
Every business is also expected to operate within set goals, which to some level may end up
facing financial risks of high levels. Even so, one should note with a lot of confidence that for
any business operations, risks are inevitable and should not prevent anyone from making an
investment.
Realization of the viability of the future of a business in terms of capital stock is also highly
proponent in risk aversion.
Recommendation
It is true that as businesses focus on maximizing output levels, thus returns generated from
different production processes, stockholders also aim at achieving high returns from their
invested capital and at constant intervals of time throughout a businesss life cycle (Tuller, 1994,
p. 202).
Before accepting to engage in a specific production processes, businesses should try and
understand the nature of complexities involved as well as possible risks under such a production
environment. Risks can be managed through proper analysis and understanding of external and
internal business environment (Tuller, 1994, p. 205).
In the event where the possibility of reducing specific operational risks is zero then the
production analysis would be more ideal compared to making an investment in a business
environment that is very risky. Investors on the same note should be able to interpret presented
information by companies over risks involved and expected returns.
This return as well as risk analysis would also put investors on the verge of choosing what is
more ideal to them. The intention is to maximize on returns arising from production processes.
From such incidences, more specifically example 1, a rational investor should be in a position to
link his or her interests to make an investment to the company that would guarantee high returns
and being subjected to share stocks as a way of achieving an environment that is less risky. The
underlying factor is that many stockholders are risk averse and it means they do not interact often
with business plans that are risky.
REFERENCES
Denne, M., & Cleland-Huang, J. (2004). Software by numbers: Low-risk, high-return
development. Upper Saddle River, NJ: Prentice Hall PTR.
Douglas, L. G. (1988). Yield curve analysis: The fundamentals of risk and return. New York:
New York Institute of Finance.
Friend, I., Bicksler, J. L., American Telephone and Telegraph Company., & Conference on Risk
and the Rate of Return. (1977). Risk and return in finance. Cambridge, Mass: Ballinger Pub. Co.
Tuller, L. W. (1994). High-risk, high-return investing. New York: J. Wiley & Sons.
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