Risk and Rates of Return

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 staff's 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.

CPC's reputation for quality and for friendly, knowledgeable employees allowed the company to expand rapidly. By March 1997 the company operated six "mega-stores" 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, stu­dents, 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 company's profit­ability. In spite of this success, Randy feels he operates in his father's shadow.

Randy's 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 Kathy's operation, and he thinks that the cyber-cafe would provide a perfect joint venture in which to develop his own business repu­ta­tion. 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 restau­rant 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 Randy's 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 investors' decisions and how investors' perceptions affect the "true risk" of corporate decisions.

To help make the discussion more concrete, the consultants con­tacted 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 investors' required return. The consultants' 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

1. Expected returns on stocks consist of an expected dividend yield plus an expected capital gains yield. The dividend yield is relatively pre­dictable, 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 stocks' 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 de­cline 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

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 devia­tion 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 port­folio composed of CPC and EAT? Explain how the correlation coef­ficient 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 spread­sheet model for the case, determine the expected return and stand­ard 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 "portfolio standard deviation" on the vertical axis and "number of stocks" 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 compen­sate 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 Enterprises' 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 investors' 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 infla­tion lead to lower returns in the short run followed by higher returns in the long run?

11. Rather than focusing on risk from an investors' decision-making per­spective, consider the risk of corporate decisions and how investors' perceptions affect the "true risk" 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 firm's 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?