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# Risk and Return, Case Study

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P5-3 Risk preferences: Sharon Smith, the financial manager for Barnett Corporation, wishes to evaluate three prospective investments: X, Y, and Z. Currently, the firm earns 12% on its investments, which have a risk index of 6%. The expected
return and expected risk of the investments are as follows:

Investment Expected return Expected risk index
X 14% 7%
Y 12% 8%
Z 10% 9%

a. If Sharon were risk-indifferent, which investments would she select? Explain why.
b. If she were risk-averse, which investments would she select? Why?
c. If she were risk-seeking, which investments would she select? Why?
d. Given the traditional risk preference behavior exhibited by financial managers, which investment would be preferred? Why?

P5-4 Risk analysis: Solar Designs is considering an investment in an expanded product line. Two possible types of expansion are being considered. After investigating the possible outcomes, the company made the estimates shown in the
following table:

EXPANSION A EXPANSION B
Initial investment \$12,000 12,000
Annual rate of return
Pessimistic 16% %10
Most likely 20% 20%
Optimistic 24% 30%

a. Determine the range of the rates of return for each of the two projects.
b. Which project is less risky? Why?
c. If you were making the investment decision, which one would you choose? Why? What does this imply about your feelings toward risk?
d. Assume that expansion B's most likely outcome is 21% per year and that all other facts remain the same. Does this change your answer to part c? Why?

P5-13 Portfolio analysis: You have been given the return data shown in the first table on three assets-F, G, and H-over the period 2007-2010.

Year Asset F Asset G Asset H
2007 16% 17% 14%
2008 17 16 15
2009 18 15 16
2010 19 14 17

Using these assets, you have isolated the three investment alternatives shown in the following table:

Alternative Investment
1 100% of assets F
2 50% of asset F and 50% of asset G
3 50% of asset F and 50% of asset H

a. Calculate the expected return over the 4-year period for each of the three alternatives.
b. Calculate the standard deviation of returns over the 4-year period for each of the three alternatives.
c. Use your findings in parts a and b to calculate the coefficient of variation for each of the three alternatives.
d. On the basis of your findings, which of the three investment alternatives do you recommend? Why?

10.4 Basic sensitivity analysis: Murdock Paints is in the process of evaluating two mutually exclusive additions to its processing capacity. The firm's financial analysts have developed pessimistic, most likely, and optimistic estimates of the annual cash inflows associated with each project. These estimates are shown in the following table.

Project A Project B
Initial investment (CFo) \$8,000 \$8,000
Outcome Annual cash inflows (CF)
Pessimistic \$200 \$900
Most likely \$1,000 \$1,000
Optimistic \$1,800 \$1,100

a. Determine the range of annual cash inflows for each of the two projects.
b. Assume that the firm' s cost of capital is 10% and that both projects have 20-year lives. Construct a table similar to this for the NPVs for each project. Include the range of NPVs for each project.
c. Do parts a and b provide consistent views of the two projects? Explain.
d. Which project do you recommend? Why?

Text Case Study: Assessing the Goal of Sports Products, Inc. located at the end of Chapter One.

Respond to the questions at the end of the Case. (at least 800 words)

a. What should the management of Sports Products, Inc., pursue as its overriding goal? Why?
b. Does the firm appear to have an agency problem? Explain.
c. Evaluate the firm's approach to pollution control. Does it seem to be ethical? Why might incurring the expense to control pollution be in the best interests of the firm's owners despite its negative effect on profits?
d. Does the firm appear to have an effective corporate governance structure? Explain any shortcomings on the basis of the information

Case: Assessing the Goal of Sports Products, Inc.
Loren Seguara and Dale Johnson both work for Sports Products, Inc., a major producer of boating equipment and accessories. Loren works as a clerical assistant in the Accounting Department, and Dale works as a packager in the
Shipping Department. During their lunch break one day, they began talking about the company. Dale complained that he had always worked hard trying not to waste packing materials and efficiently and cost-effectively performing his job.
In spite of his efforts and those of his co-workers in the department, the firm's stock price had declined nearly \$2 per share over the past 9 months. Loren indicated that she shared Dale's frustration, particularly because the firm's profits
had been rising. Neither could understand why the firm's stock price was falling as profits rose. Loren indicated that she had seen documents describing the firm's profitsharing plan under which all managers were partially compensated on the basis
of the firm's profits. She suggested that maybe it was profit that was important to management, because it directly affected their pay. Dale said, "That doesn't make sense, because the stockholders own the firm. Shouldn't management do what's
best for stockholders? Something's wrong!" Loren responded, "Well, maybe that explains why the company hasn't concerned itself with the stock price. Look, the only profits that stockholders receive are in the form of cash dividends, and this
firm has never paid dividends during its 20-year history. We as stockholders therefore don't directly benefit from profits. The only way we benefit is for the stock price to rise." Dale chimed in, "That probably explains why the firm is being sued by state and federal environmental officials for dumping pollutants in the adjacent stream. Why spend money for pollution control? It increases costs, lowers profits, and therefore lowers management's earnings!"

Loren and Dale realized that the lunch break had ended and they must quickly return to work. Before leaving, they decided to meet the next day to continue their discussion.

a. What should the management of Sports Products, Inc., pursue as its overriding goal? Why?
b. Does the firm appear to have an agency problem? Explain.
c. Evaluate the firm's approach to pollution control. Does it seem to be ethical? Why might incurring the expense to control pollution be in the best interests of the firm's owners despite its negative effect on profits?
d. Does the firm appear to have an effective corporate governance structure? Explain any shortcomings.

#### Solution Preview

P5-3 Risk preferences Sharon Smith, the financial manager for Barnett Corporation, wishes to evaluate three prospective investments: X, Y, and Z. Currently, the firm earns 12% on its investments, which have a risk index of 6%. The expected return and expected risk of the investments are as follows:

Investment Expected return Expected risk index
X 14% 7%
Y 12% 8%
Z 10% 9%

a. If Sharon were risk-indifferent, which investments would she select? Explain why.

A risk indifferent person would select the investment with the highest return
X gives the highest return; hence she would choose X

b. If she were risk-averse, which investments would she select? Why?

A risk averse person selects the investments which give the highest return for a given level of risk or the lowest risk for a given level of return
Thus she would not choose X as the returns are the highest (14%) with the lowest risk of 7%

c. If she were risk-seeking, which investments would she select? Why?

A risk seeking person would go for highest risk: Z (risk of 9%)

d. Given the traditional risk preference behavior exhibited by financial managers, which investment would be preferred? Why?

Traditionally managers are risk averse- hence X would be preferred.

P5-4 Risk analysis Solar Designs is considering an investment in an expanded product line. Two possible types of expansion are being considered. After investigating the possible outcomes, the company made the estimates shown in the following table:

EXPANSION A EXPANSION B
Initial investment \$12,000 12,000
Annual rate of return
Pessimistic 16% 10%
Most likely 20% 20%
Optimistic 24% 30%

a. Determine the range of the rates of return for each of the two projects.

A: Range= 24%-16% =8%
B: Range= 30%-10%= 20%

b. Which project is less risky? Why?

Project A is less risky. The range of returns for A is lower than that of B. (while the most likely return is the same for both the projects)

c. If you were making the investment decision, which one would you choose? Why? What does this imply about your feelings toward risk?

I will choose A as it gives the same most likely return as B (20%) with lesser risk.
It implies that I am a risk-averse investor.
A risk averse investor selects an investment which gives the lowest risk for a given level or return (or the highest return for a given level of risk)

d. Assume that expansion B's most likely outcome is 21% per year and that all other facts remain the same. Does this change your answer to part c? Why?

This can change the outcome. Now the return is higher for project B (along with a higher risk). Thus different investors can choose either of projects A and B depending on their risk tolerance.

P5-13 Portfolio analysis You have been given the return data shown in the first table on three assets-F, G, and H-over the period 2007-2010.

Expected return
Year Asset F Asset G Asset H
2007 16% 17% 14%
2008 17% 16% 15%
2009 18% 15% 16%
2010 19% 14% 17%

EXPECTED RETURN

Using these assets, you have isolated the three investment alternatives shown in the following table:

Alternative Investment
1 100% of asset F
2 50% of asset F and 50% of asset G
3 50% of asset F and 50% of asset H

Let us first calculate the returns of investment alternatives
Year 100% of asset F 50% of asset F and 50% or asset G 50% of asset F and 50% of asset H
2007 16% 16.5% =50% x16.%+ 50% x ...

#### Solution Summary

Answers questions on risk and return and questions on a case study: Assessing the Goal of Sports Products, Inc.

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