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Post-Graduate Program

-Advanced Financial Management

-ACFN 631

12/13/2018

Course Overview

• Course Outline.docx

12/13/2018

CHAPTER-1

RISK MANAGEMENT &

LEVERAGE ANALYSIS

12/13/2018

Lecture Flow:

Concept Uncertainty and Risk

Types of Risk

Measurement of Risk ( Standard Deviation and

Beta)

Systematic and Unsystematic Risk

Diversification and Portfolio Risk

The Security Market Line(SML)

Markowitz's portfolio theory

The Capital Asset Pricing Model(CAPM) and

Arbitrage Pricing Theory(APT)

Fama-French 3-Factor Model

12/13/2018

Con’t…

• The concept of leverage

• Introduction

• What is business risk and financial risk?

• Types of leverages

– Operating leverage

– Financial leverage

– Combined leverage

• Effects of financial plan on EPS and ROE at a

constant EBIT

• Effects of financial plan on EPS and ROE at a varying

EBIT

12/13/2018

Learning Objectives

• After you read this chapter, you should be able to

answer the following questions:

What do we mean by risk aversion?

portfolio theory?

alternative measures of risk used in investments?

individual

12/13/2018

risky asset or a portfolio of assets?

Con’t…

• How do you compute the standard deviation of

rates of return for an individual risky asset?

return, and how do you compute covariance?

correlation?

portfolio of risky assets, and how does it differ from

the standard deviation of an individual risky asset?

12/13/2018

Con’t…

• Given the formula for the standard deviation of a

portfolio, why and how do you diversify a portfolio?

when you change the correlation between the assets in

the portfolio?

with Constant Correlation between the assets in the

portfolio and with Changing Weights assets in the

portfolio?

12/13/2018

Con’t…

• Explain the concept of financial leverage.

leverage.

leverage.

financial

12/13/2018

risk.

What is Uncertainty ?

• Whenever you make a financing or investment

decision, there is some uncertainty about the outcome.

• Uncertainty means not knowing exactly what will

happen in the future.

• There is uncertainty in most everything we do as

financial managers, because no one knows

precisely what changes will occur in such things as

– tax laws,

– consumer demand,

– the economy, or

– interest rates.

12/13/2018

Con’t….

Benjamin Franklin pointed out:

“In this world nothing can be said to be certain,

except death and taxes”.

used to mean the same thing, there is a distinction

between them.

• Uncertainty is not knowing what’s going to happen.

Risk is how we characterize how much uncertainty

exists: The greater the uncertainty, the greater the risk.

– Risk is the degree of uncertainty.

Risk Analysis

12/13/2018

Risk --- What is this?

• Consider the two cases.

1)Mr Ramesh has put his money in National Bank of Ethiopia

(NBE) bond where he is going to get 12% p.a.. He is really happy

with the rate of return. Will he have sleepless nights, if the

economy goes into recession?.

Answer: Of course no.

2) Mr. Ramesh is very bullish/Optimistic with the stock market

and invests money into equity diversified fund with the

expectation that he will get 15% return. Will he have sleepless

nights if economy goes into deep recession, and now he feels that

he may get negative returns of say 5-7%?

Answer: Of course yes.

• In the second situation, he has a fear, which is the result of huge

difference in his expected return and the actual return, which he

may get. This difference itself is the risk that he bears. Does he face

this kind of difference in the first situation? No. So there is no risk.

What is risk ?

• Literally risk is defined as “exposing to danger or

hazard”.

Which is perceived as negative terms.

“exposing to danger or hazard”

given decision which can be assigned probabilities”

12/13/2018

Con’t…

In finance,

• Risk refers to the likelihood that we will receive

a return on an investment that is different from

the return we expected to make.

results (rates of return) deviates from expected

returns.

12/13/2018

Con’t…

• Thus, risk includes not only the bad outcomes (returns

that are lower than expected), but also good

outcomes (returns that are higher than expected).

and the latter as upside risk.

12/13/2018

What is Risk ?

• Chinese Symbol for Risk: The first symbol is the

symbol for “danger” while the second is the symbol for

“opportunity”, making risk a mix of danger and

opportunity.

12/13/2018

Sources of Risk

12/13/2018

Sources of Risk Con’t…

Business Risk:

• Uncertainty of income flows caused by the

nature of a firm’s business

determine the level of business risk.

12/13/2018

Source of risk Con’t…

Financial Risk

• Uncertainty caused by the use of debt financing.

(Level of Financial Leverage)

• Borrowing requires fixed payments which must

be paid ahead of payments to stockholders.

• The use of debt increases uncertainty of

stockholder income and causes an increase in the

stock’s risk premium.

12/13/2018

Source of Risk Con’t…

Liquidity Risk

• Uncertainty is introduced by the secondary

market for an investment.

– How long will it take to convert an investment

into cash?

– How certain is the price that will be received?

12/13/2018

Source of Risk Con’t…

• Exchange Rate Risk:

• Uncertainty of return is introduced by acquiring

securities denominated in a currency different

from that of the investor.

return when converting an investment back into

the “home” currency.

12/13/2018

Source of Risk Con’t…

• Country Risk:

• Political risk is the uncertainty of returns caused

by the possibility of a major change in the

political or economic environment in a country.

unstable political-economic systems must include

a country risk-premium when determining their

required rate of return

12/13/2018

Source of Risk Con’t…

Interest rate risk is the chance that changes in

interest rates will adversely affect a security’s

value.

changing price levels (inflation or deflation) will

adversely affect investment returns.

12/13/2018

Classification of Risk:

Diversifiable and Non-diversifiable Risk

• Although there are many reasons why actual returns may

differ from expected returns, we can group the reasons

into two categories:

A. Market wide/Systematic Risk and

B. Firm-specific/ Unsystematic Risk.

or a few investments, while the risks arising from market

wide reasons affect many or all investments.

• This distinction is critical to the way we assess risk in

finance.

12/13/2018

Con’t…

• 1) Systematic risk - The risk inherent to the entire

market or entire market segments is known as

systematic risk. This is also known as:

• Un-diversifiable risk" or "market risk” or “uncontrollable risk. “

wars etc all represent sources of systematic risk because

they affect the entire market and cannot be avoided

through diversification. This risk can be mitigated through

hedging.

12/13/2018

Con’t…

• 2) Unsystematic Risk – The risk which is specific to a

company or industry is known as unsystematic risk.

diversification. This is also known as "specific risk",

"diversifiable risk" or "residual risk“ or “

controllable risk.

– Employees strike

–12/13/2018

Key person leaving

Con’t…

• Components of Risk: When an investor buys stock or

takes an equity position in a firm, he or she is exposed to

many risks.

• Some risk may affect only one or a few firms, and this

risk is categorized as firm-specific risk.

risks, starting with the risk that a firm may have

misjudged the demand for a product from its customers;

we call this project risk.

12/13/2018

Con’t…

• For instance, consider Boeing’s investment in a

Super Jumbo jet. This investment is based on the

assumption that airlines want a larger airplane and

are willing to pay a high price for it. If Boeing has

misjudged this demand, it will clearly have an

impact on Boeing’s earnings and value, but it

should not have a significant effect on other firms in

the market.

12/13/2018

Con’t…

• Competition: The risk could also arise from

competitors proving to be stronger or weaker than

anticipated, called competitive risk.

competing for an order from Qantas, the Australian

airline. The possibility that Airbus may win the bid is a

potential source of risk to Boeing and perhaps some of

its suppliers, but again, few other firms will be

affected by it.

12/13/2018

Con’t…

12/13/2018

Con’t…

• Activity-1

• Why Diversification Reduces or Eliminates Firm-

Specific Risk: Give an Intuitive Explanation

12/13/2018

How is Unsystematic Risk

Reduced?

12/13/2018

What is investment risk?

with certainty.

Investment risk pertains to the probability of

earning a return less than that expected.

expected return, the greater the risk.

12/13/2018

Probability distribution

Stock X

Stock Y

Rate of

-20 0 15 50 return (%)

Which stock is riskier? Why?

12/13/2018

Answer: Con’t…

• The tighter (or more peaked) the probability distribution, the

more likely it is that the actual outcome will be close to the

expected value, and hence the less likely it is that the actual

return will end up far below the expected return.

– Thus, the tighter the probability distribution, the lower the risk

assigned to a stock.

actual return is likely to be closer to its 15% expected return than

that of Stock Y.

• According to this definition, Stock X is less risky than

Stock Y because there is a smaller chance that its actual

return will end up far below its expected return.

12/13/2018

Con’t…

2. Quantification of Historical Risk

o As it has already been mentioned, risk is nothing

but possibility that actual outcome of investment

will differ from expected outcome of investment.

Variance and standard deviations are used.

o So let’s see the basic behind usage of standard deviation

to measure the risk and also the way to calculate it.

12/13/2018

Con’t…

• The variance essentially measures the average

squared difference between the actual returns and

the average return.

returns tend to differ from the average return.

is, the more spread out the returns will be.

12/13/2018

Con’t…

• The way we will calculate the variance and standard

deviation will depend on the specific situation.

• In this section, we are looking at historical returns;

the procedure would be different from the risk of

historical returns. We describe this procedure in the

next topic.

sum of the squared deviations, by the number of returns

less 1.

12/13/2018

Con’t…

12/13/2018

Example

12/13/2018

Measuring the Expected Risk of a Single Asset

• Standard deviation is the most common statistical

indicator of an asset’s risk (stand alone risk).

• S.D measures the variability of a set of observations.

• The larger the standard deviation, the higher the

probability that returns will be far below the expected

return.

• Coefficient of variation is an alternative measure of

stand-alone risk.

12/13/2018

Con’t…

• Standard deviation is indicator of risk asset (an

absolute measure of risk) of that asset’s expected

return, σ (Ri), which measures the dispersion

around its expected value.

(deviation) of each possible outcome from the

expected value and the probability associated with

that distance.

σ (Ri) = √ [R j - E(Ri) ]2 x Pr j

12/13/2018

Con’t…

• Steps to calculate the σ or sigma:

1. Calculate the expected rate of return:

Expected rate of return, E(Ri) = (Rj x Prj)

2. Subtract the expected rate of return (E(Ri) )

from each possible outcome (ri) to obtain a

set of deviations about E(Ri), Deviationi = ri

− E(Ri)

12/13/2018

Con’t…

3. Square each deviation

Deviationi = (ri − E(Ri))2

4. Multiply the squared deviations by the probability

of occurrence for its related outcome.

Pi(ri − E(Ri) )2

5. Sum these products to obtain the variance of the

probability distribution:

6.

12/13/2018

– Coefficient of Variation is a statistical measurement

of relative dispersion of an asset return. It is useful in

comparing the risk of assets with differing average or

expected return.

– Formula for CV is:

Coefficient of Variation = Standard Deviation

Average or Expected Return

CV = σ (Ri)

E(Ri)

_ It is often preferable to measure dispersion as an asset’s variance,

Var(Rj) where it is defined in equation below:

Var(Rj)= σ 2 (Ri) = [R j - E(Ri) ]2 x Pr j

12/13/2018

Determining Standard Deviation

(Risk Measure)

n

s= ( Ri - R )2( Pi )

i=1

Standard Deviation, s, is a statistical measure of

the variability of a distribution around its mean.

It is the square root of variance.

Note, this is for a discrete distribution.

12/13/2018

How to Determine the Expected Return and

Standard Deviation

Stock BW

Ri Pi (Ri)(Pi)

The

-.15 .10 -.015 expected

-.03 .20 -.006 return, R,

.09 .40 .036 for Stock

.21 .20 .042 BW is .09

or 9%

.33 .10 .033

Sum 1.00 .090

12/13/2018

How to Determine the Expected Return and

Standard Deviation

Stock BW

Ri Pi (Ri)(Pi) (Ri - R )2(Pi)

-.15 .10 -.015 .00576

-.03 .20 -.006 .00288

.09 .40 .036 .00000

.21 .20 .042 .00288

.33 .10 .033 .00576

Sum 1.00 .090 .01728

12/13/2018

MEASURING EXPECTED (EX ANTE)

RETURN AND RISK

EXPECTED RATE OF RETURN

n

E (R) = pi Ri

i=1

STANDARD DEVIATION OF RETURN

s = [ pi (Ri - E(R) )2]

i. State of the

Economy pi Ri piRi Ri-E(R) (Ri-E(R))2 pi(Ri-E(R))2

1. Boom 0.30 16 4.8 4.5 20.25 6.075

2. Normal 0.50 11 5.5 -0.5 0.25 0.125

3. Recession 0.20 6 1.2 -5.5 30.25 6.050

E(R ) = piRi = 11.5 pi(Ri –E(R))2 =12.25

σ = [pi(Ri-E(R))2]1/2 = (12.25)1/2 = 3.5%

12/13/2018

Comments on Standard Deviation as a

Measure of Risk

• Standard deviation (σi) measures total, or stand-

alone, risk.

• The larger σi is, the lower the probability that actual

returns will be closer to expected returns.

• Larger σi is associated with a wider probability

distribution of returns.

greater variation of returns and thus a greater

chance that the expected return will not be realized.

• The larger the Standard deviation (σi), the higher

the risk, because Standard deviation (σi), is a

measure

12/13/2018

of total risk.

Investor’s Level of Risk

• While both products have the same expected value, they differ in

the distribution of possible outcomes. When we calculate the

standard deviation around the expected value, we see that Product

B has a larger standard deviation.

has more risk than Product A since its possible outcomes are more

distant more from its expected value.

12/13/2018

Con’t…

• Which product investment do you prefer, A or B?

Most people would choose A since it provides the

same expected return with less risk.

Does this mean a risk averse person will not take

on risk? No—they will take on risk if they

feel they are compensated for it. i.e.

Risk Averse – describes an investor who requires

greater return in exchange for greater risk.

•

12/13/2018

Con’t…

• A risk neutral person is indifferent toward risk.

Risk neutral persons do not need compensation for

bearing risk.

willing to pay to take on risk.

• Risk Seeking (Risk Taker) – describes an investor who

will accept a lower return in exchange for greater risk.

• Are there such people? Yes. Consider people who play

the state lotteries, where the expected value is always

negative:

– The expected value of the winnings is less than the cost

of the lottery ticket.

12/13/2018

Con’t…

Models

Introduction

• Risk–return trade-offs have an important role to play in corporate

finance theory – from both a company and an investor

perspective.

• Companies face variability in their projected cash flows whereas

investors face variability in their capital gains and dividends.

• Assuming that companies and shareholders are rational, their aim

will be to minimise the risk they face for a given return they expect

to receive.

• So in this chapter we will examine how investors, by ‘not putting

all their eggs in one basket’, are able to reduce the risk they face

given the level of their expected return.

12/13/2018 21 - 57

Con’t…

• PORTFOLIO: is a collection or a group of investment

assets. If you hold only one asset, you suffer a loss if the

return turns out to be very low.

• If you hold two assets, the chance of suffering a loss is

reduced and returns on both assets must be low for you to

suffer a loss.

move proportionately in the same direction at the same

time, you reduce your risk.

12/13/2018 21 - 58

Con’t…

• It is the total portfolio risk and return that is important.

The risk and return of individual assets should not be

analyzed in isolation; rather they should be analyzed in

terms of how they affect the risk and return of the

portfolio in which they are included.

efficient portfolio, one that maximizes return for a given

level of risk or minimizes risk for a given level of return.

12/13/2018 21 - 59

Ex Post Portfolio Returns

Simply the Weighted Average of Past Returns

n

Rp x

i 1

i Ri

Where :

xi relative weight of asset i

Ri Actual return on asset i

Rp Portifolio Expost Re turn

n Numberofstock sin theportfolio

12/13/2018

145

Portfolio-Expected Return

• The expected return on a portfolio, ˆrp, is simply the

weighted average of the expected returns on the individual

assets in the portfolio, with the weights being the fraction of

the total portfolio invested in each asset:

n

Formula : E(Rp)=

WiRi

i 1

Where:

Rp = Expected Return of the Portfolio.

Wi = The weights attached for each security.

ri = Expected return of a security.

n = No of stocks/securities in a portfolio.

12/13/2018 21 -- 61

21 61

Con’t…

• Note; “Wi” is the fraction of the portfolio’s dollar value

invested in stock/security i, that is, the value of investment in

stock i divided by the total value of the portfolio. Thus, the sum

of Wi’s must be 1.00.

• Example: Consider a portfolio of three stocks A, B, and C,

with expected returns of 16%, 12%, and 20% respectively. The

portfolio consists of 50% stock A, 25% stock B, and 25%

stock C.

• Required: what is the expected return on this portfolio?

• E(Rp)= .16*50+.12*25+.20*25= 16% which is the expected

return of a portfolio

12/13/2018 21 - 62

21 - 62

PORTFOLIO EXPECTED RETURN Con’t…

Example-2: A portfolio consists of four securities with expected

returns of 12%, 15%, 18%, and 20% respectively. The proportions of

portfolio value invested in these securities are 0.2, 0.3, 0.3, and 0.20

respectively.

n

E(RP) = wi E(Ri)

i=1

where E(RP) = expected portfolio return

wi = weight assigned to security i

E(Ri) = expected return on security i

n = number of securities in the portfolio

Then expected return on the portfolio of the above Example is:

E(RP) = 0.2(12%) + 0.3(15%) + 0.3(18%) + 0.2(20%)

12/13/2018 21 -- 63

21 63

= 16.3%

Ex Ante Portfolio Returns

Simply the Weighted Average of Expected Returns

Example-3:

Relative Expected Weighted

Weight Return Return

Stock X 0.400 8.0% 0.03

Stock Y 0.350 15.0% 0.05

Stock Z 0.250 25.0% 0.06

Expected Portfolio Return = 14.70%

12/13/2018 21 - 64

145- 64

21

Risk in a Portfolio Context

simply the weighted average of the expected returns on

the individual assets in the portfolio.

deviation of a portfolio, is generally not the weighted

average of the standard deviations of the individual

assets in the portfolio; the portfolio’s risk will almost

always be smaller than the weighted average of the

assets’ S.D’s.

12/13/2018 21 - 65

21 - 65

Con’t…

• Portfolio risk can be reduced by the simple kind of diversification,

that is; when different assets are added to the portfolio, the total risk

tends to decrease.

• Total risk of portfolio consists of systematic risk & unsystematic risk

and this total risk is measured by the variance and standard deviation

of the rate of return overtime.

• As the portfolio size increases, the total risk decreases up to a certain

level. Beyond that limit, risk cannot be reduced.

– This indicates that spreading out the assets beyond certain level can’t be

expected to reduce the portfolio’s total risk below the level of un-

diversifiable risk.

12/13/2018 21 - 66

Investors Risk Tolerance

choose A since it provides the same expected return with less risk.

• Most people do not like risk—they are risk averse. Does this mean a

risk averse person will not take on risk? No—they will take on risk if they

feel they are compensated for it.

12/13/2018 21 - 67

Con’t…

• A risk neutral person is indifferent toward risk. Risk

neutral persons do not need compensation for bearing

risk.

• A risk preference person likes risk—someone even

willing to pay to take on risk.

Therefore:

• Portfolio theory always assumes that investors are

basically risk averse, meaning that, given a choice

between two assets with equal rates of return, they will

select the asset with the lower level of risk.

12/13/2018 21 - 68

Modern Portfolio Theory

( Markowitz's):

12/13/2018

Harry Markowitz

• In the early 1960s, the investment community talked

about risk, but there was no specific measure for the

term.

quantify their risk variable.

Markowitz, who derived the expected rate of return

for a portfolio of assets and an expected risk measure.

12/13/2018

Con’t…

• Modern portfolio theory was initiated by University of

Chicago graduate student, Harry Markowitz in 1952.

just the weighted average sum of the risks of the

individual securities…but rather, also a function of the

degree of co movement of the returns of those individual

assets.

12/13/2018 21 - 71

Risk and Return – Modern Portfolio Theory

(MPT)

• Prior to the establishment of Modern Portfolio Theory,

most people only focused upon investment

returns…they ignored risk.

• With MPT, investors had a tool that they could use to

dramatically reduce the risk of the portfolio without a

significant reduction in the expected return of the

portfolio.

• Markowitz showed that the variance of the rate of

return was a meaningful measure of portfolio risk

under a reasonable set of assumptions, and he derived

the formula for computing the variance of a portfolio.

12/13/2018 3

Assumptions of the Markowitz Model:

• The Markowitz model is based on several

assumptions regarding investor behaviour:

1. Investors consider each investment alternative as

being represented by a probability distribution of

expected returns over some holding period.

2. Investors maximize one-period expected utility, and

their utility curves demonstrate diminishing

marginal utility of wealth.

3. Investors estimate the risk of the portfolio on the

basis of the variability of expected returns.

12/13/2018 21 - 73

Con’t…

4. Investors base decisions solely on expected return

and risk, so their utility curves are a function of

expected return and the expected variance (or

standard deviation) of returns only.

returns to lower returns. Similarly, for a given level

of expected return, investors prefer less risk to more

risk.

12/13/2018 21 - 74

Con’t…

• Therefore:

Under these assumptions, a single asset or

portfolio of assets is considered to be efficient if

no other asset or portfolio of assets offers higher

expected return with the same (or lower) risk, or

lower risk with the same (or higher) expected

return.

12/13/2018 21 - 75

Diversifying unsystematic risk using a

two-share portfolio

• The simplest portfolio to consider is that containing two

shares.

• Diversification is the combination of assets whose returns do not

vary with one another in the same direction at the same time.

unsystematic risk depends on the correlation between the

two shares’ returns.

• This correlation is quantified by the correlation coefficient () of

the returns of the two shares, which can take any value in the

range -1 to +1.

12/13/2018

Correlation

• Correlation (co-movement): refers to the association of

movement between two numbers.

two variables, such as returns on two assets, move

together.

12/13/2018 10

Con’t…

• While the positive or negative sign indicates the direction of the

co-movement.

• The closer the correlation coefficient is to +1 or -1, the stronger the

association.

– +1 is perfect positive correlation.

– -1 is perfect negative correlation.

– 0.0 no relationship

• If the variables move together, they are

positively correlated (a positive correlation

coefficient).

• If the variables move in opposite direction, they

are negatively correlated (a negative correlation).

12/13/2018

Con’t…

• A correlation of +1.0 indicates that the variables move

up and down together, the relative magnitude of the

movements is exactly the same (perfect positive

correlation).

opposite to each other. (Perfect negative correlation).

between the variables, that is they are unrelated.

12/13/2018 21 - 79

Con’t…

usually move up and down together, but not all

the time. The closer the correlation is to 0.0, the

lesser the two sets of returns move together.

indicates negative, but not perfect negative

correlation between the two assets’ returns.

12/13/2018 21 - 80

Perfect Negatively Correlated Returns over Time

Returns

% A two-asset portfolio

made up of equal

parts of Stock A and

B would

be riskless. There

would be no

10% variability

of the portfolios

returns over time.

Returns on Stock A

Returns on Stock B

Returns on Portfolio

12/13/2018 1994 1995 1996 Time 2111- 81

Con’t…

If (A,B) =+1 no unsystematic risk can be diversified away

If (A,B =-1 all unsystematic risk will be diversified away

If (A,B)= 0 no correlation between the two securities’ returns

beneficial to choose two shares whose correlation

coefficient is as close to -1 as possible.

than +1, some unsystematic risk will be diversified

away.

12/13/2018

Con’t…

• In practice it is difficult to find two securities whose

correlation coefficient is exactly -1, but the most

commonly quoted example is that of an umbrella

manufacturer and an ice cream company.

portfolio consists of perfectly positively correlated stocks.

12/13/2018 21 - 83

COVARIANCE OF RETURNS

• Covariance measures how closely security returns

move together. The covariance between possible returns

for securities J and K,

• When we consider two assets in the portfolio, we are

concerned with the co-movement of security movement.

• Co-movements between the returns of securities are measured by

covariance (an absolute measure) and coefficient of correlation (a

relative measure).

• It can be:

• positive Covariance,

• negative Covariance, and

• zero Covariance,

12/13/2018 21 - 84

Con’t…

• A positive covariance between the returns of two securities

indicates that the returns of the two securities tend to move

in the same direction.

indicates that the returns of the two securities tend to move

in opposite directions.

two securities indicates that there is little or no relationship

between the returns of the two securities;

• We denote the covariance between the return of security i

and the return of security j by (the Greek letter sigma,sij

or covariance ij).

12/13/2018

COVARIANCE

• Covariance will flow with the following steps:

• Step 1: Calculate the expected return for each assets

• Step 2: For each scenario and investment, subtract the

investment’s expected return from its possible outcome.

• Step 3: For each scenario, multiply the deviations for the two

investments.

• Step 4: Weight this product by the scenario’s probability.

• Step 5: Sum these weighted products to arrive at the covariance.

12/13/2018 21 - 86

Con’t….

••

•• + p2 [Ri2 – E(Rj)] [Rj2 – E(Rj)]

12/13/2018 21 -- 87

21 87

ILLUSTRATION

The returns on assets 1 and 2 under five possible states of nature are given below

1 0.10 -10% 5%

2 0.30 15 12

3 0.30 18 19

4 0.20 22 15

5 0.10 27 12

E(R1) = 0.10 (-10%) + 0.30 (15%) + 0.30 (18%) + 0.20 (22%) + 0.10 (27%) = 16%

E(R2) = 0.10 (5%) + 0.30 (12%) + 0.30 (19%) + 0.20 (15%) + 0.10 (12%) = 14%

12/13/2018

State of Probability Return on Deviation of Return on Deviation of Product of the

nature asset 1 the return on asset 2 the return on deviations

asset 1 from its asset 2 from times

mean its mean probability

(1) (2) (3) (4) (5) (6) (2) x (4) x (6)

2 0.30 15% -1% 12% -2% 0.6

3 0.30 18% 2% 19% 5% 3.0

4 0.20 22% 6% 15% 1% 1.2

5 0.10 27% 11% 12% -2% -2.2

Sum = 26.0

Thus the covariance between the returns on the two assets is 26.0.

12/13/2018

Coefficient of Correlation

• Correlation measures the degree of linear relationship to which

two variables, such as returns on two assets, move together.

12/13/2018

Co-effient of Correlation

Cov (Ri , Rj)

Cor (Ri , Rj) or ij = si sj

sij

=

si sj

sij = ij . si . sj

where ij = correlation coefficient between the returns on

securities i and j

sij = covariance between the returns on securities

i and j

si , sj = standard deviation of the returns on securities

i and j

12/13/2018 21 - 91

That is:

12/13/2018 21 - 92

Grouping Individual Assets into

Portfolios

• The riskiness of a portfolio that is made of different risky assets is

a function of three different factors:

– the riskiness of the individual assets that make up the portfolio

– the relative weights of the assets in the portfolio

– the degree of co-movement of returns of the assets making up the portfolio.

• The standard deviation of a two-asset portfolio may be measured

using the Markowitz model:

s p s w s w 2w1w2 1,2s 1s 2

2 2

1 1

2 2

2 2

12/13/2018 21 - 93

PORTFOLIO RISK : 2 – SECURITY CASE

Example : w1 = 0.6 , w2 = 0.4,

s1 = 10%, s2 = 16%

12 = 0.5

sp = [0.62 x 102 + 0.42 x 162 +2 x 0.6 x 0.4 x 0.5 x 10 x 16]½

= 10.7%

The average standard deviation of two securities is 13, which is less

than standard deviation of the portfolio, which is 10. Thus

diversification reduces risk.

12/13/2018 21 - 94

Risk of a Three-asset Portfolio

The data requirements for a three-asset portfolio grows

dramatically if we are using Markowitz Portfolio selection

formulae.

We need 3 (three) correlation coefficients between A and B; A

and C; and B and C.

A

ρa,b ρa,c

B C

ρb,c

12/13/2018 21 - 95

PORTFOLIO RISK : 3 – SECURITY CASE

sp = [ wi wj ij si sj ] ½

Example : w1 = 0.5 , w2 = 0.3, and w3 = 0.2

s1 = 10%, s2 = 15%, s3 = 20%

12 = 0.3, 13 = 0.5, 23 = 0.6

sp = [w12 s12 + w22 s22 + w32 s32 + 2 w1 w2 12 s1 s2

+ 2w2 w3 13 s1 s3 + 2w2 w3 23s2 s3] ½

= [0.52 x 102 + 0.32 x 152 + 0.22 x 202

+ 2 x 0.5 x 0.3 x 0.3 x 10 x 15

+ 2 x 0.5 x 0.2 x 05 x 10 x 20

+ 2 x 0.3 x 0.2 x 0.6 x 15 x 20] ½

12/13/2018 = 10.79% 21 - 96

Risk of a Four-asset Portfolio

dramatically if we are using Markowitz Portfolio

selection formulae.

We need 6 correlation coefficients between A and B;

A and C; A and D; B and C; C and D; and B and D.

A

ρa,b ρa,d

ρa,c

B D

ρb,d

ρb,c ρc,d

C

12/13/2018 21 - 97

Risk of a Four-asset Portfolio

dramatically if we are using Markowitz Portfolio

selection formulae.

We need 6 correlation coefficients between A and B;

A and C; A and D; B and C; C and D; and B and D.

A

ρa,b ρa,d

ρa,c

B D

ρb,d

ρb,c ρc,d

C

12/13/2018 21 - 98

Example

a standard deviation of 20 percent. Asset B has an

expected return of 16 percent and a standard deviation of

40 percent. If the correlation between A and B is 0.6,

what are the expected return and standard deviation for a

portfolio comprised of 30 percent Asset A and 70 percent

Asset B?

12/13/2018 21 - 99

Portfolio Expected Return

0.3(0.1) 0.7(0.16)

0.142 14.2%.

12/13/2018 21 - 100

Portfolio Standard Deviation

s p WA2s A2 (1 WA ) 2 s B2 2WA (1 WA ) AB s A s B

0.32 ( 0.22 ) 0.7 2 ( 0.4 2 ) 2( 0.3)( 0.7 )( 0.4)( 0.2)( 0.4)

0.309

12/13/2018 21 - 101

Equal Risk and Return—Changing

Correlations

• Consider first the case in which both assets have the same

expected return and expected standard deviation of return. As an

example, let us assume

E(R1) = 0.20

σ1 = 0.10

E(R2) = 0.20

σ2 = 0.10

• To show the effect of different covariance's, assume different

levels of correlation between the two assets. Consider the

following examples where the two assets have equal weights

in the portfolio (W1 = 0.50; W2 = 0.50). Therefore, the only value

that changes in each example is the correlation between the returns

for the two assets. Recall that, Covij = rijσiσj

12/13/2018 21 - 102

Con’t…

• Consider the following alternative correlation coefficients and the

covariance's they yield. The covariance term in the equation will be

equal to r1,2 (0.10)(0.10) because both standard deviations are 0.10.

a. r1,2 = 1.00; Cov1,2 = (1.00)(0.10)(0.10) = 0.010

b. r1,2 = 0.50; Cov1,2 = (0.50)(0.10)(0.10) = 0.005

c. r1,2 = 0.00; Cov1,2 = 0.000(0.10)(0.10) = 0.000

d. r1,2 = –0.50; Cov1,2 = (–0.50)(0.10)(0.10) = –0.005

e. r1,2 = –1.00; Cov1,2 = (–1.00)(0.10)(0.10) =–0.01

12/13/2018 21 - 103

Con’t…

deviation of the portfolio under these five

conditions.

• Recall from previous Equation that:

s p s w s w 2w1w2 1,2s 1s 2

2 2

1 1

2 2

2 2

12/13/2018 21 - 104

Con’t…

12/13/2018 21 - 105

Con’t…

are perfectly positively correlated (r 1,2 = +1.0),

the standard deviation for the portfolio is, in fact,

the weighted average of the individual standard

deviations.

• The important point is that we get no real benefit

from combining two assets that are perfectly

correlated; they are like one asset already because

their returns move together.

Now

12/13/2018 consider Case b, where r 1,2 equals 21

0.50:

- 106

The only term that changed from Case a is the last term, Cov1,2,

which changed from 0.01 to 0.005. As a result, the standard

deviation of the portfolio declined by about 13 percent, from

0.10 to 0.0868. Note that the expected return did not change

because it is simply the weighted average of the individual

expected returns; it is equal to 0.20 in both cases.

the standard deviations for Portfolios c and d are as follows:

c. 0.0707

12/13/2018 d. 0.05 21 - 107

12/13/2018 21 - 108

Standard Deviation of a Portfolio

individual standard deviations

– Negative correlation reduces portfolio risk

– Combining two assets with +1.0 correlation will not

reduces the portfolio standard deviation

– Combining two assets with -1.0 correlation may reduces

the portfolio standard deviation to zero

– See next Exhibits:

12/13/2018

Exhibit

12/13/2018

Standard Deviation of a Portfolio:

With Different Returns and Risk

• Combining Stocks with Different Returns and Risk :

the correlation coefficient (covariance) differs between

the assets.

expected rates of return and individual standard deviations.

12/13/2018 21 - 111

Standard Deviation of a Portfolio:

Different Returns and Risk

• Two Stocks with Different Returns and Risk

Asset E(Ri ) Wi σ 2i σi

1 .10 .50 .0049 .07

2 .20 .50 .0100 .10

a +1.00 .0070

b +0.50 .0035

c 0.00 .0000

d -0.50 -.0035

e -1.00 -.0070

12/13/2018

12/13/2018 21 - 113

12/13/2018 21 - 114

Exhibit

12/13/2018 21 - 115

Standard Deviation of a Portfolio:

With Constant Correlation but Changing Weights of Assets

• Two Stocks with Different Returns and Risk

Asset E(Ri ) σ 2i σi

1 .10 .0049 .07

2 .20 .0100 .10

12/13/2018 21 - 116

Constant Correlation with Changing Weights

of Assets

• Constant Correlation with Changing Weights

– Assume the correlation is 0 in the earlier example and let

the weight vary as shown below.

– Portfolio return and risk are (See Exhibit 7.13):

Case W1 W2 E(Ri) E(σport)

f 0.00 1.00 0.20 0.1000

g 0.20 0.80 0.18 0.0812

h 0.40 0.60 0.16 0.0662

i 0.50 0.50 0.15 0.0610

j 0.60 0.40 0.14 0.0580

k 0.80 0.20 0.12 0.0595

l 1.00 0.00 0.10 0.0700

12/13/2018

12/13/2018

Exhibit

12/13/2018

Diversification Potential

• The potential of an asset to diversify a portfolio is

dependent upon the degree of co-movement of returns of

the asset with those other assets that make up the

portfolio.

• In a simple, two-asset case, if the returns of the two assets

are perfectly negatively correlated it is possible

(depending on the relative weighting) to eliminate all

portfolio risk.

• This is demonstrated through the following chart.

12/13/2018 21 - 120

Constant Correlation with

Changing Weights of Assets

Expected Standard Correlation

Perfect Positive

Asset Return Deviation Coefficient Correlation – no

A 5.0% 15.0% 1 diversification

B 14.0% 40.0%

Expected Standard

Weight of A Weight of B Return Deviation

100.00% 0.00% 5.00% 15.0%

90.00% 10.00% 5.90% 17.5%

80.00% 20.00% 6.80% 20.0%

70.00% 30.00% 7.70% 22.5%

60.00% 40.00% 8.60% 25.0%

50.00% 50.00% 9.50% 27.5%

40.00% 60.00% 10.40% 30.0%

30.00% 70.00% 11.30% 32.5%

20.00% 80.00% 12.20% 35.0%

10.00% 90.00% 13.10% 37.5%

0.00% 100.00% 14.00% 40.0%

12/13/2018 21 - 121

Example of Portfolio Combinations

and Correlation

Expected Standard Correlation

Positive

Asset Return Deviation Coefficient Correlation – weak

A 5.0% 15.0% 0.5 diversification

B 14.0% 40.0% potential

Expected Standard

Weight of A Weight of B Return Deviation

100.00% 0.00% 5.00% 15.0%

90.00% 10.00% 5.90% 15.9%

80.00% 20.00% 6.80% 17.4%

70.00% 30.00% 7.70% 19.5%

60.00% 40.00% 8.60% 21.9%

50.00% 50.00% 9.50% 24.6%

40.00% 60.00% 10.40% 27.5%

30.00% 70.00% 11.30% 30.5%

20.00% 80.00% 12.20% 33.6%

10.00% 90.00% 13.10% 36.8%

0.00% 100.00% 14.00% 40.0%

12/13/2018 21 - 122

Example of Portfolio Combinations

and Correlation

Expected Standard Correlation No Correlation –

Asset Return Deviation Coefficient some

A 5.0% 15.0% 0 diversification

B 14.0% 40.0% potential

Expected Standard

Weight of A Weight of B Return Deviation

100.00% 0.00% 5.00% 15.0%

90.00% 10.00% 5.90% 14.1% Lower

80.00% 20.00% 6.80% 14.4% risk than

70.00% 30.00% 7.70% 15.9%

60.00% 40.00% 8.60% 18.4%

asset A

50.00% 50.00% 9.50% 21.4%

40.00% 60.00% 10.40% 24.7%

30.00% 70.00% 11.30% 28.4%

20.00% 80.00% 12.20% 32.1%

10.00% 90.00% 13.10% 36.0%

0.00% 100.00% 14.00% 40.0%

12/13/2018 21 - 123

Example of Portfolio Combinations

and Correlation

Expected Standard Correlation

Negative

Asset Return Deviation Coefficient Correlation –

A 5.0% 15.0% -0.5 greater

B 14.0% 40.0% diversification

potential

Portfolio Components Portfolio Characteristics

Expected Standard

Weight of A Weight of B Return Deviation

100.00% 0.00% 5.00% 15.0%

90.00% 10.00% 5.90% 12.0%

80.00% 20.00% 6.80% 10.6%

70.00% 30.00% 7.70% 11.3%

60.00% 40.00% 8.60% 13.9%

50.00% 50.00% 9.50% 17.5%

40.00% 60.00% 10.40% 21.6%

30.00% 70.00% 11.30% 26.0%

20.00% 80.00% 12.20% 30.6%

10.00% 90.00% 13.10% 35.3%

0.00% 100.00% 14.00% 40.0%

12/13/2018 21 - 124

Example of Portfolio Combinations

and Correlation Perfect Negative

Expected Standard Correlation Correlation –

Asset Return Deviation Coefficient greatest

A 5.0% 15.0% -1 diversification

B 14.0% 40.0% potential

Expected Standard

Weight of A Weight of B Return Deviation

100.00% 0.00% 5.00% 15.0%

90.00% 10.00% 5.90% 9.5%

80.00% 20.00% 6.80% 4.0% Risk of the

70.00% 30.00% 7.70% 1.5% portfolio is

60.00% 40.00% 8.60% 7.0% almost

50.00% 50.00% 9.50% 12.5% eliminated at

40.00% 60.00% 10.40% 18.0% 70% asset A

30.00% 70.00% 11.30% 23.5%

20.00% 80.00% 12.20% 29.0%

10.00% 90.00% 13.10% 34.5%

0.00% 100.00% 14.00% 40.0%

12/13/2018 21 - 125

Diversification of a Two Asset Portfolio Demonstrated

Graphically

The Two-Asset Case

Expected Return B

AB = -0.5

12%

AB = -1

8%

AB = 0

AB= +1

A

4%

0%

Standard Deviation

12/13/2018 21 - 126

• ASSIGNMENT With Presentation:

Capital Asset Pricing Model (CAPM)

Arbitrage pricing theory

Fama-French 3-factor model

12/13/2018

Leverage Analysis

12/13/2018

The concept of Leverage

• The leverage concept is very general:

– It is not unique to business or finance, and it can be

used to analyze many different types of problems.

For example, other disciplines, such as economics

and engineering, use the same concept, and refer to it

as elasticity.

– When used in a financial setting, leverage measures

the behavior of interrelated variables, such as:

• output, revenue, earnings before interest and taxes

(EBIT), and earnings per share (EPS).

12/13/2018

Meaning of Leverage

• The term leverage refers to an increased means of

accomplishing some purpose.

not be otherwise possible.

– In the financial point of view, leverage refers to furnish

the ability to use fixed cost assets or funds to increase the

return to its shareholders

12/13/2018

130

Financial Risk Vs. Business Risk

• Financial risk:

– is the likelihood of bankruptcy due to exposure to

excessive debt and other fixed financing cost items such

as leasing.

– Financial risk increases with the increase in debt ratio.

• Business risk:

– Is the general risk factor-internal and external that affect

the firm’s profitability.

– examples of business risk;

• Financial crises, economic recession, competition, labour

problem, corporate fraud, product and pricing problem and

operating leverage

12/13/2018

131

Types of Leverage

• Leverage can be classified into three major headings

according to the nature of the finance mix of the

company.

A. Operating Leverage

B. Financial Leverage

C. Composite Leverage

• The company may use financial leverage or

operating leverage, to increase the EBIT and EPS.

12/13/2018

132

Types of Leverage

12/13/2018

133

Operating Leverage

• Operating Leverage measures the relationship

between Sales and Earning before interest and tax

(EBIT), specifically; it measures the effect of

changing levels of sales on EBIT.

• Earning before interest and tax = Total revenue – Total variable cost –

fixed cost.

• When the level of sales changes from its initial value,

the initial value of EBIT also changes.

• A simple indication of operating leverage is the

effect that a change in sales has an effect on earnings.

12/13/2018

134

Operating Leverage Con’t…

• Operating leverage can be calculated with the help of

the following formula:

OL = CM/EBIT

Where:

OL = Operating Leverage

CM= Contribution Margin, Sales – Variable Cost

EBIT= Earning Before Interest and Tax or Operating Income

12/13/2018

135

Operating Leverage, Con’t….

Degreeof

• Degree OfOperating

OperatingLeverage

Leverage (DOL)

(DOL) is defined

is defined as the resulting percentage change in

EBIT resulting from a percentage change in the

sales.

• it can be calculated with the help of the following

formula:

DOL= Percentage Change in EBIT

Percentage Change in Sales

12/13/2018

136

Degree of Operating Leverage Formula (DOL)

Con’t..

• The degree of

operating leverage

(DOL) is defined as

the percentage % Change in EBIT

change in the DOL

% Change in Sales

earnings before

interest and taxes EBIT/EBIT

DOL

(EBIT0 relative to a Sales/Sales

given percentage

change in sales.

12/13/2018

137

Con’t….

12/13/2018

138

Con’t…

• Comments:

• Operating leverage for B Company is higher than

that of A Company; B Company has a higher degree

of operating risk.

• The tendency of operating profit may vary

portionately with sales, is higher for B Company as

compared to A Company. Uses of Operating

Leverage

12/13/2018

139

Operating Leverage, Con’t….

Degree Of Operating Leverage (DOL)

12/13/2018

140

Operating Leverage, Con’t….

• Example-2: Assume that

Degree Of Operating the price

Leverage (DOL)per unit of

output (p) is Br. 10, and variable cost per unit of

output (VC) is Br. 4, and fixed cost (FC) is Br.

30,000, and the level of output (X) is 8000 units. By

using the formula EBIT is computed as follows:

EBIT = Total revenue – Total variable cost – fixed cost

EBIT = TP – TVC – FC

or EBIT = X (P – VC) – FC

EBIT = 8000 (Br. 10 – Br. 4) – Br. 30,000

12/13/2018 = Br. 18,000

141

Operating Leverage, Con’t….

Degree Of Operating Leverage (DOL)

• Now assume that the level of output increases from

8000 to 10,000 units. The resulting EBIT is

computed as:

EBIT = 10,000 (Br. 10 – Br. 4) – Br. 30,000

= Br. 30,000

– Percentage change in output = 2000/8000 = 25%

– Percentage change in EBIT = Br. 12000/Br. 18000 = 66.7%

12/13/2018

142

Operating Leverage, Con’t….

Degree Of Operating Leverage (DOL)

Coefficient of operating leverage = % change in EBIT

% change in output or Sales

Coefficient of operating leverage= 66.7%/25%= 2.67 times

initial value of 8000 units produces a 2.67 percent change in

EBIT. Since output increased by 25 percent from its initial

value of 8000 units, EBIT increases by (2.67)x(.25) = .667

or 66.7 percent.

12/13/2018

143

Financial Leverage

• Questions while Making the Financing Decision

– How should the investment project be financed?

matter?

– How does financing affect the shareholders’ risk, return and value?

value to the firm’s shareholders?

– Can the optimum financing mix be determined in practice for a

company?

– What factors in practice should a company consider in designing its

financing policy?

12/13/2018

144

Meaning of Financial Leverage

• The use of the fixed-charges sources of funds, such as debt

and preference capital along with the owners’ equity in the

capital structure, is described as financial leverage or

gearing or trading on equity.

earn more return on the fixed-charge funds than their costs.

The surplus (or deficit) will increase (or decrease) the return

on the owners’ equity.

below the rate of return on total assets.

12/13/2018

145

Financial Leverage

risk and arises from fixed financial costs. One

way to measure financial leverage is to determine

how earnings per share are affected by a change in

EBIT (or operating income).

12/13/2018

146

Financial Leverage Formula Con’t..

Financial leverage can be

calculated with the help of

• FL = EBIT/EPS

the following formula: Where:

FL = Op/PBT FL= Financial Leverage

Where: EBIT= Operating Profit

Fl= Financial Leverage EPS= Earning Per Share

Op=Operating Profit (EBIT)

PBT = Profit Before Tax

12/13/2018

147

Degree of Financial Leverage con’t…

• Financial leverage measures the relationship between

EBIT and earning per share (EPS). Specifically, it

reflects the effect of changing levels of EBIT on

EPS.

• The functional relationship between these two variables is

i.e. EPS = f (EBIT)

Federal income taxes (t)= (profit before taxes) (tax rate) = (EBIT– I) (t)

12/13/2018

148

Degree of Financial Leverage con’t…

profit after tax: profit before taxes – federal income taxes

(EBIT – I) – (EBIT – I) (t) or

(EBIT – I) (1 – t)

profit after taxes – preferred stock dividends

(EBIT – I) (1 – t) – E

Earning available to common shareholders= Profit after tax – E

Earning per share of common stock=

Earning available to common shareholders

number of common shares issued

EPS = (EBIT – I) (1 – t) – E

12/13/2018

N 149

Degree of Financial Leverage con’t…

12/13/2018

Example-1

12/13/2018

151

Example-2

Assume that I = Br. 100,000, t = 0.4, E = Br. 80,000

N = 60,000, and EBIT = Br. 500,000. The EPS at this level of

EBIT is

Computed as:

EPS = (Br. 500,000 – Br. 100,000) (1 – 0.4) – Br. 80,000

60,000

= Br. 2.67

If EBIT increases from Br. 500,000 to Br. 600,000, the resulting

EPS is:

EPS = (Br. 60,000 – Br. 100,000) (1 – 0.4) – Br. 80,000

60,000

12/13/2018

= Br. 3.67

152

Example Con’t…

The financial leverage is computed as:

Percentage change in EBIT = Br. 100,000/Br. 500,000 = 20%

Percentage change

in EPS = Br. 1/Br. 2.67 = 37.45%

• DFL= % change in EPS/% change in EBIT

0.3745/0.20 = 1.87 times

The coefficient of financial leverage of 1.87 is interpreted as

follows:

A 1 percent change in EBIT from an initial value of Br.

500,000 produces a 1.87 percent change in EPS. Since

EBIT increased by 20 percent from its initial value, EPS

increased

12/13/2018 by 1.87 (0.20) = 0.374 or 37.4 percent. 153

Combined Leverage

• When the company uses both financial and

operating leverage to magnification of any change

in sales into a larger relative changes in earning per

share.

• Operating leverage affects a firm’s operating profit

(EBIT), while Financial leverage affects profit

after tax or the earnings per share.

• The degrees of operating and financial leverages is

combined to see the effect of total leverage on

EPS associated with a given change in sales.

12/13/2018

154

Combined Leverage Con’t…

• Combined leverage express the relationship

between the revenue in the account of sales and the

taxable income.

• Combined leverage is also called:

– Composite leverage or

– Total leverage.

12/13/2018

155

Combined Leverage con’t…

12/13/2018

156

Degree of Combined Leverage

con’t…

• The percentage change in a firm’s earning per share

(EPS) results from one percent change in sales.

• This is also equal to the firm’s degree of operating

leverage (DOL) times its degree of financial leverage

(DFL) at a particular level of sales.

12/13/2018

157

Degree of Combined Leverage con’t…

12/13/2018

158

Degree of Combined Leverage

con’t…

% Change in EBIT % Change in EPS % Change in EPS

% Change in Sales % Change in EBIT % Change in Sales

Q( s v) Q( s v) F Q( s v)

DCL

Q( s v) F Q( s v) F INT Q( s v) F INT

12/13/2018

159

THANK U

AND

HAVE A NICE DAY!

12/13/2018

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