MAF203 : Risk and Return- Risk Management Assessment

Risk Management Assessment

Case Scenario/ Task

Part A: Risk and Return (20 marks)

Use yahoo finance to find historical prices of the US market index S&P 500 (^GSPC) and thefollowing three companies traded in the U.S market: Google (GOOG), Walmart (WMT) andToyota (TM):

• Go to https://au.finance.yahoo.com
• Type in the company ticker in the Look Up window
• Click on Historical Prices on the left panel of the page
• Set date range from 01/01/2011 to 31/12/2015 and choose Daily

Frequency.

• Download the data from Download to Spreadsheet button at the endof the page.

(See Appendix for screenshot of each step)

Note: We assume that the performance of S&P 500 represents the average performance of theU.S market.

Questions

• Using daily price from the data, compute 2015 monthly Holding Period Return(HPR) of the above stocks and index using adjusted Close Price (Adj Close). (4marks)

Hint: HPRMonth t = Price end of the month?Price beginning of the month

Price begining of the month

• Compute the standard deviation of the above stocks and index using monthly HPR inpart (a). (4 marks)

Hint: Use Excel function STDEV.S() to compute standard deviation of a series.

• Compute the (monthly) return correlation coefficient between any two of the abovestocks. (3 marks)

Hint: Use Excel function CORREL() to compute the correlation coefficient between twodata series.

• Using the correlation coefficient, comment on the return movement of these stocks inthe specified date range. (2 marks)

• If you were to form a portfolio of 2 stocks, which ones are your choice to maximisediversification benefit? Explain the rationale behind your investment choice. (4 marks)

• If you were to invest in the two stocks in question 5 equally, what is the standarddeviation of your portfolio for 2015. (3 marks)

Part B: Capital Budgeting (30 marks)

Myer Inc. would like to set up a new plant. Currently, Myer has an option to buy an exsitingbuilding at a cost of $24,000. Necessary equipment for the plant will cost $16,000, including

installation costs. Depreciation of the equipment and of the building is as follows:

Year 1=$3512, Year 2= $5744, Year 3=$3664, and Year 4= $2544.

The project would require an initial investment of $12,000 of net working capital and will bemade at the time of the purchase of the building and equipment. The working capital will befully recovered at end of year 4.

The project’s estimated economic life is four years. At the end of that time, the building isexpected to have a market value of $15,000 and a book value of $21,816, whereas theequipment is expected to have a market value of $4000 and a book value of $2720.

Annual sales will be $80,000. The production department has estimated that variablemanufacturing costs will be 60% of sales and that fixed overhead costs, excluding depreciation,will be $10,000 a year ( hint: total costs = 0.6*80,000+10,000=58,000).

Myer’s marginal tax is 40%; its cost of capital is 12% and for capital budgeting purposes, thecompany’s policy is to assume that operating cashflows occur at the end of each year. The plantwill begin operations immediately after the investment is made, and the first operating cashflows will occur exactly one year later.

Questions:

• Compute: • the initial investment outlay. (3 marks)

• operating cashflows over the project’s life. (8 marks)
• the terminal-year cashflows for Myer’s expansion project. (3 marks)

• Determine whether the project should be accepted using NPV analysis. (6 marks)
• Perform a sensitivity analysis on NPV of the project on the following scenarios:
• Sales increases/decreases by 10%. (3 marks)
• Cost of capital increases/decreases by 10%. (3 marks)

c. Both (a) and (b). (4 marks)

Part – A

Solution to Question -1

The calculation for 2015 monthly Holding Period Return for S&P 500, Google, Walmart and Toyota is as under:

The above calculation has been done using the formula:

Where,

Price end of the month = Open

Price beginning of the month = Adj Close

Solution to Question No -2

The calculations for Standard Deviation for the above Index and Stocks:

The above calculations are being done using excel formula STDEV.S ().

Solution to Question No – 3

The correlation to coefficient for Google and Walmart is as under using excel formula CORREL ():

Solution to Question no – 4

In the portfolio consisting of Google and Walmart, as the correlation coefficient is almost zero both are unrelated. Google as a comparative lower returns in positive as compared to Walmart. Over the period of time the returns from the stock will be almost zero as the correlation is near to zero. The profits from Walmart will be negated by the losses from Google stock.

Solution to Question No – 5

Out of the above three stocks it is preferable to choose Google and Toyota as the correlation for both are highest and thus they are considered to be related. With higher correlation it is good to achieve the diversification benefits. Unrelated stocks lack diversification. The rationale between choosing the two is the relation between them and the same being positive. The calculation for the same is shown below:

Solution to Question No – 6

The Standard Deviation is 9.33 for the above two stocks. The calculations for the same is shown as under:

Part – B

Solution to Question No – 1

Initial Outlay = Cost of Building + Cost of Equipment + Net Working Capital

= $ 24,000 + $ 16,000 + $ 12,000 = $ 52,000

Operating Cash Flows over the period of time = (Revenues – Costs)* (1-40%)

Year 1 = ( 80000 – 60*80000 – 10000 – 3512) * (0.60) = $ 11,093

Year 2 = (80000 – 60*80000 – 10000 – 5744) * (0.60) = $ 9,754

Year 3 = (80000 – 60*80000 – 10000 – 3664) * (0.60) = $ 11,002

Year 4 = (80000 – 60*80000 – 10000 – 2544) * (0.60) = $ 11,674

The terminal year cash flow is as under:

Net Working Capital $ 12,000

Salvage Value of Building $ 15,000

Salvage Value of Equipment $ 4,000

Tax effect on loss $ 3,322

Operating Cash Flow $ 11,674

Total Terminal Year Cash Flow $ 45,996

Solution to Question No – 2

The project is not viable as the Net Present Value of the Project is positive hence it should be accepted. Myer’s would be able to recover its investment in full and as well as gain some income to the extent of $ 396. This income of $ 396 is over and above the desired return of Myer at a cost of capital of 12%. A project with negative NPV is not feasible. The calculation for the same is as under:

Solution to Question No – 3

• An increase in sales by 10% Percent would result in an increase in income by $ 23,484. Whereas a decrease would result in project becoming unviable to accept as the NVP of the project would be negative and Myer would not be able to recover the investment in full as well as the cost of capital.

• An increase in Cost would again make the project unviable and cause losses to Myer. Whereas decrease in cost would result in NPV to go up by $ 17,026. This is shown in the calculation below:

• A simultaneous increase in Sales and increase in Cost would have zero effect on the NPV of the project and similarly for decrease in sales and decrease in cost. But in case where sales increases and cost decreases the NPV of the project will rise and it would be more profitable to Myer. Whereas an increase in cost and decrease in sales would result in NPV becoming negative and project becoming unviable.