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Considerations for Investments

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139 #1, 5 (under questions sections), pg. 140 #2, 3 (under problems section)
1#. Comment on the following statements:
a. "Because our new expansion project has the same systematic risk as the firm as a whole, we need do no further risk analysis on the project."

b. "Our company should accept the new potash mine project at Moosejaw. The cost of additional loans to fund the project is 12 percent, and our simulations lead us to expect a 14 percent return from the project."
c. "It is difficult to decide whether to spend $10 million to reopen our mine because the price of gold is so uncertain. However, if we assume the price of gold grows at an average of 5 percent a year with a standard deviation of 20 percent a year, simulation indicates the mine has an average NPV of $500,000. Therefore, we should reopen."
5# what is the advantage of using certainty-equivalent cash flows instead of risk-adjusted discount rates to calculate the NPV of an investment project?

#2 In early 1990, Boeing Co. decided to gamble $4 billion to build a new long-distance, 350-seat wide-body airplane called the Boeing 777. The price tag for the 777, scheduled for delivery beginning in 1995, is about $120 million apiece. Assume that Boeing's $4 billion investment is made at the rate of $800 million a year for the years 1990 through 1994 and that the present value of the tax write-off associated with these costs is $750 million. Based on estimated annual fixed costs of $100 million, variable production costs of $90 million apiece, a marginal corporate tax rate of 34 percent and a discount rate of 14 percent, what is the break-even quantity of annual unit sales over the Boeing 777's projected 15-year life? Assume that all cash inflows and outflows occur at the end of the year.

3# The recently opened Grand Hyatt Wailea Resort and Spa on Maui cost $600 million, about $800,000 per room, to build. Daily operating expenses average $135 a room if occupied and $80 a room if unoccupied (much of the labor cost of running a hotel is fixed). At an average room rate of $500 a night, a marginal tax rate of 40 percent, and a cost of capital of 11 percent, what year-round occupancy rate do the Japanese investors who financed the Grand Hyatt Wailea require to break even in economic terms on their investment over its estimated 40-year life? What is the likelihood that this investment will have a positive NPV? Assume that the $450 million expense of building the hotel can be written off straight line over a 30-year period (the other $150 million is for the land which is not depreciable) and that the present value of the hotel's terminal value will be $200 million.

4#
Compare the assumptions underlying Arbitrage Pricing Theory with those underlying the mean-variance Capital Asset Pricing Model. Which set of assumptions seems more realistic to you? Why?

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This particular set of questions deals with the return criteria for determining if investments are, or will be successful. As such, it is involved with measurement criteria for trying to determine the decision process for entering into an investment. Before starting, let's review the three basic criteria for measuring the success of any investment opportunity. The three principles involved are:

* the net present value rule which states that if the investment has a POSITIVE net present value (determined by measuring a forecast of returns from the investment over time), then the investment is acceptable to the firm. The positive net present value is determined by discounting future cash flows to the present (using a discount factor which is related to gaining the desired return), then determining if the sum of these incremental returns will be positive in relation to the initial investment amount. Stated in finance terms then, if NPV is => than 0, then the investment decision is to go with the investment.

* the internal rate of return rule also states that the investment needs to have a return which is greater than the existing return, or equal to or greater than the existing cost of capital (or both). In this case we are trying to determine if we will cover both the cost for funding the project, as well as determine if we can gain a return which is NO LESS than we are currently enjoying. Stated financially then the IROR (internal rate of return) needs to be => the current rate of return AND/OR => the current cost of capital for funding the project.

* the payback rule deals with the gain or return within predetermined time levels, which allows the firm to receive the initial outlay for the investment within a predetermined amount of time such that the firm essentially breaks even on the investment. With most firms this predetermined amount of time is usually 36 months (but it can vary depending upon projected future returns, public relations determinations, and the like).

Given this set of parameters, we can now move toward answering each question.

a. "Because our new expansion project has the same systematic risk as the firm as a whole, we need do no further risk analysis on the project."

By definition, we can view systematic risk as follows:

In finance and economics, systematic risk (in economics often called aggregate risk or undiversifiable risk) is vulnerability to events which affect aggregate outcomes such as broad market returns, total economy-wide resource holdings, or aggregate income. In many contexts, events like earthquakes and major weather catastrophes pose aggregate risks—they affect not only the distribution but also the total amount of resources. If every possible outcome of a stochastic economic process is characterized by the same aggregate result (but potentially different distributional outcomes), then the process has no aggregate risk.

Properties of systematic risk
Systematic or aggregate risk arises from market structure or dynamics which produce shocks or uncertainty faced by all agents in the market; such shocks could arise from government policy, international economic forces, or acts of nature. In contrast, specific risk (sometimes called residual risk or idiosyncratic risk) is risk to which only specific agents or industries are vulnerable (and is uncorrelated with broad market returns). Due to the idiosyncratic nature of unsystematic risk, it can be reduced or eliminated through diversification; but since all market actors are vulnerable to systematic risk, it cannot be limited through diversification (but it may be insurable). As a result, assets whose expected returns are negatively correlated with broader market returns command higher prices than assets not possessing this property.

In some cases, aggregate risk exists due to institutional or other constraints on market completeness. For countries or regions lacking access to broad hedging markets, events like earthquakes and adverse weather shocks can also act as costly aggregate risks. Robert Shiller has found that, despite the globalization progress of recent decades, country-level aggregate income risks are still significant and could potentially be reduced through the creation of better global hedging markets (thereby potentially becoming idiosyncratic, rather than aggregate, risks).[1] Specifically, Shiller advocated for the creation of macro futures markets. The benefits of such a mechanism would depend on the degree to which macro conditions are correlated across countries.

Systematic risk in finance
Systematic risk plays an important role in portfolio allocation.[2] Risk which cannot be eliminated through diversification commands returns in excess of the risk-free rate (while idiosyncratic risk does not command such returns since it can be diversified). Over the long run, a well-diversified portfolio provides returns which correspond with its exposure to systematic risk; investors face a trade-off between returns and systematic risk. Therefore, an investor's desired returns correspond with their desired exposure to systematic risk and corresponding asset selection. Investors can only reduce a portfolio's exposure to systematic risk by sacrificing returns.

An important concept for evaluating an asset's exposure to systematic risk is Beta. Since Beta indicates the degree to which an asset's expected return is correlated with broader market outcomes, it is simply an indicator of an asset's vulnerability to systematic risk. Hence, the capital asset pricing model (CAPM) directly ties an asset's equilibrium price to its exposure to systematic risk.

Based upon the definition of systematic risk noted above, we can see that this type of risk is associated with market conditions which CANNOT be diversified away. In essence, there is little or no control over this type of risk because it emanates from the market place --- it is external to the firm. As such, we can conclude that this type of risk is very high, which means that the firm will REQUIRE a HIGHER LEVEL OF RETURN. The finance principle involved is the risk/reward principle which states that if a firm is willing to take a higher risk, it should also expect or require a higher return for undertaking the risk. Correspondingly, we can also make the argument that higher risk can result in little or no returns based upon the notion that it all could be lost due to the risky nature of the investment.

In the context of this statement, then, we need to know and understand the nature of the risk currently employed by the firm with respect to its current investments and its associated criteria. If the firm currently is involved with high risk types of investments, then the statement is essentially true --- there needs to be little else done. However, if the firm has taken a more moderate approach to its investment strategy, then further analysis is definitely required in order to determine if the investment fits the criteria noted above in the three principles which will determine the potential success of the investment. Further we need to understand that the elements of risk do not remain the same --- they are fluid based upon changes in economic conditions. For example, if interest rates drop significantly, this will allow the firm to take advantage of attractive borrowing rates for funding the project, which may result in lowering risk due to a reduced cost of capital. However, if this same lowering of interest rates results in high unemployment and loss of purchasing power for consumers. then, even though there is a lower cost to fund the project, we may incur higher risk due to a change in demand from the consumer perspective. So the real determination then is that we need to perform due diligence with respect to ALL investments, and not make assumptions about economic conditions which tend to be fluid in nature.

Second question is:

b. "Our company should accept the new potash mine project at Moosejaw. The cost of additional loans to fund the project is 12 percent, and our simulations lead us to expect a 14 percent return from the project."

Based upon this set of criteria, and based upon the internal rate of return rule stated above, this would hold credence for investing. In this case the rate of return EXCEEDS the current rate of return. The prime factor, as mentioned above, is that the investment project needs to contribute in excess of the current return, which this particular opportunity does. This set of information does not mention the risk elements, so we would need to add the caveat that, IF THE RISK ELEMENTS REMAIN RELATIVELY THE SAME, then our logic to accept this ...

Solution Summary

The expert examines discussing a set of questions designed to illuminate the factors related to decision making for entering into investment opportunities

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