Download lecture 02 - risk and return relationship

Risk and return
relationship
Lecture 2
Lecture outline
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What is risk?
How risk is measured?
Types of risk
Risk Characteristics of Technology Start-ups
Risk and return trade-off
Risk and project life cycle
Risk management framework
Conclusion: Questions to ask.
What is risk?
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Risk presents when the possible outcomes
may deviate from the expected outcomes.
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More than one possible outcomes
Actual outcome may be different from expected.
Can have both upside and downside risks
Heavy focus on the downside risks
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But remember there is a potential upside otherwise why
should anyone take risks?
Let’s go an example
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You are interested in a venture in the chemical
industry. You have researched for the price to
earnings ratios of the listed firms in the industry.
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These P/E ratios provide a ground to estimate the
possible P/E value for your prospect firm.
P/E ratios of 80 Bio-chemical firms
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34
16
49
45
14
15
10
41
37
27
10
12
25
49
19
39
13
29
7
23
31
44
39
49
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14
32
15
15
45
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33
45
5
13
47
28
22
12
31
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26
46
23
40
50
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41
39
9
39
43
40
44
40
13
14
32
7
35
34
34
9
25
20
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20
47
30
30
25
37
45
32
42
31
24
23
41
These price to earnings ratios can be
organised in the form of an array…
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A probability distribution can be derived for the
data set…
Price/Earnings
Ratio
Frequency
(# of stocks)
Relative
Frequency
0 to 10
8
0.16
11 to 20
15
0.30
21 to 30
18
0.36
31 to 40
20
0.40
41 to 50
19
0.38
Data are grouped into classes and the number of observations.
A frequency distribution can be presented using
histograms and frequency polygons…
Frequency Polygon
Histogram
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20
15
15
10
10
5
5
0
10
20
30
40
50
P/E
Ratio
0
10
20
30
40
50
P/E
Ratio
Important parameters
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A population can be measured by its:
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Central tendency (average performance)
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Mean
Mode
Median
Dispersion (range of possible outcomes)
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Range
Standard Deviation
Variance
Mean value (Expected value)
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The arithmetic mean gives the
expected value of a population,
denoted as E(X):
X
x  E( X ) 
N
Example:
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The price/earnings ratios (X) of
six company stocks are:
10, 11, 12, 14, 14, 50
The expected value (mx) of
price/earnings ratios of this group
of stocks is given by:
10  11  12  14  14  50
x  E( X ) 
 18.5
6
Notes on using mean value (expected)
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Arithmetic mean is defined by all values in a data
set.
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“Outliers” may result in a distorted measure of central tendency
Need to consider other values such as modes and median.
Modes and median are not affected by the outliers.
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In the previous example: 10, 11, 12, 14, 14, 50
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Mode is 14.
Median is 13
So what can we say about the expected P/E?
Risk measured by dispersion
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Range – simplest measure of dispersion
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The range is the difference between the highest
and lowest values in the population.
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In the previous example: 10, 11, 12, 14, 14, 50
The range of the price/earnings ratios of the 6
stocks is Rx = 50 – 10 = 40
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Risk measured by dispersion
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Variance:
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
a common measure of risk
Variance of a population is:
2
x
(X  


X
)
2
N
The variance of the price/earnings ratio of the five stocks is calculated as follows:
X-X
(X-X )2
10
10 - 18.5 = -8.5
72.25
11
11 - 18.5 = -7.5
56.25
12
12 - 18.5 = -6.5
42.25
14
14 - 18.5 = -4.5
20.25
14
14 - 18.5 = -4.5
20.25
50
50 – 18.5 = 31.5
992.25
X
111
1203.5
1203.5
 
 200.58
6
2
x
Risk measured by dispersion
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Standard deviation
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The standard deviation of a population is the square root of its
variance…
x  
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2
x
Very sensitive to extreme values
 x   x2  200.58  14.16
For a continuous normal random variable, the
probability distribution has the following
characteristics…
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68%
95%
99.7%
4
3
2

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2
3
4
Standard
Deviation From
The Mean
Interpreting the results
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Expected value = 18.5
Standard deviation = 14.2
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68% chance: P/E falls into the range: 4.3 – 32.7
95% chance: P/E falls into the range: 0 – 46.9
99% chance: P/E falls into the range: 0 – 61.1
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Note the impact of the outliers in this calculation.
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Using probability distribution….
EXAMPLE
If a company is expected to earn $1.50 per share with a standard
deviation of $0.20, the confidence limits on the actual earnings
are:
Probability
Range of actual earnings
68%
$1.50 +/- $0.20 i.e.
$1.30 to $1.70
95%
$1.50 +/- 1.96*$0.20 i.e.
$1.11 to $1.89
99.7%
$1.50 +/- 3*$0.20 i.e.
$0.90 to $2.10
Class quiz
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If a company share price is expected to be
$10 and its daily standard deviation is $2.
What is the chance of having the price to go
up to $20 in one day?
Measuring Risk
Low risk project
Standard
deviation 
High risk project
-ve
0
+ve
Expected returns
Please comment:
Firm X
Firm Y
-70
0
15
Expected Rate of Return
100
Rate of
Return (%)
Risk: Portfolio vs Stand-Alone
There are two aspects of risk to be considered
in examining a technology venture in relation
to the portfolio and to individual projects
Risk: Portfolio vs Stand-Alone
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Stand-alone: not diversifiable
Portfolio risk: diversifiable
Portfolio Risk Implications:
 Risk analysis may imply that the multi project
start-up, be able to spread its risk over a number
of project might be more willing to take on higher
financing costs, whereas the single project startup is more conservative in its financing strategy
 Risk tolerance of the start-up will depend on the
risk aversion of the owners.
Types of project risk
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Three typical types of project risks:
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stand-alone risk,
corporate risk and
market risk
Project stand-alone risk
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What is the project’s stand-alone risk?
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Project risk relates to the uncertainty about
future operating income (EBIT),
How well can we predict operating income?
Corporate risk
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How the project fits in with the current
corporate strategy and structure
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Financial aspects
Human resource aspects (esp. management)
Marketing and strategy
If the project fails, will it affect the other
business of the firm?
If the firm fails in any other business, how this
project is going to be influenced?
Market risk
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How the market may impact on the project
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Commodity markets
Financial markets
Interest rate market
Foreign exchange markets
An indicator of market risk is BETA.
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Beta: systematic (market) risk of the business
Note: Firm beta vs. project beta
Company Betas
CNET Networks
EDS
Nokia
Oracle
SAP
CISCO
Microsoft
AOL-Time Warner
2.27
0.61
2.05
1.76
1.56
2.00
1.80
2.57
Source: Yahoo Finance, 24 April 2002
How to estimate BETA?
How to interpret BETA value?
Australian E-Commerce Returns and Volatility
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Company
My Casino
Sausage Software
Solution 6
Reckon Group
Swish Group
Pocketmail
131.shop.com
B2B.Net.Technology
Coms 21
Etrade Australia
AOL
Candle
Liberty One
Spike Networks
Webjet
Travel.com
Ecorp
Wine Planet
Std. Deviation
59.59%
28.58%
38.43%
19.54%
22.55%
296.52%
24.06%
801.31%
19.22%
19.57%
82.44%
11.25%
31.17%
45.45%
29.67%
67.28%
33.03%
56.22%
Beta
0.03
5.29
5.57
2.96
4.05
3.70
4.81
-23.51
1.46
0.09
6.24
2.61
-1.16
7.50
2.71
2.81
4.31
11.95
How to estimate Beta?
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Regression
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Stock returns against market returns  firm’s beta
If the project is funded with the same D/E structure as
the current structure  use the firm beta as the project
beta
If the project is funded with equity only  find the
unlevered beta from the firm beta.
U 
L
D
1
E
How to estimate Beta?
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What if it is not a public company?
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Find beta of a comparable firm
Adjust for leverage level
What if there is no comparable company?
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Entrepreneurial venture
Use earnings beta (find by regression)
Why take risks?
Risk – Return Trade-Off
Therefore the decision
to proceed with a new
project development,
i.e. commitment of
resources, should be
based on an assessment
of expected returns
from the project against
its risk exposures.
Risk – Return Trade-Off
In this context, management should ask the
following risk related questions:
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3.
4.
Is the new project crucial to the firm’s performance and how
does it fit with the firm business strategy?
Does the startup possess or have access to the necessary
expertise/experience to successfully complete the project?
What is the level of resources to be committed?
What is the expected risk-return trade off in the project?
Risk and return trade-off
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The greater the risk the greater the
potential to create value – but also the
greater potential to destroy value.
Risk Characteristics of Technology
Start-ups
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extremely risky
Depends on the level of experience and
technical skills
Track record
Risk to future firms’ revenue and profitability
More difficult to estimate cash flow
More difficult to estimate discount rate
Risks change over project life cycle
Risk and Technology Start-ups
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A highly risky project may achieve a certain
degree of market success, but with
considerable costs, such as:
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longer PLC
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higher costs
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lower profit margins
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loss of market share
Risk and Technology Start-ups
Factors influencing risk level of technology
start-ups:
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The potential market size;
The type of financing available and cost;
The technical and scientific basis and support for
the project;
The degree of previous experience with the
technology, both within the firm and in other
companies;
Proximity of the performance and physical
specifications to the limits of the technology;
Risk and Technology Start-ups
Critical management decisions:
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4.
what risk to take
what investment to make
when to proceed to the next step in the cycle
when to terminate a program
Risk and Technology Start-ups
The relationship between the degree of risk
exposure a firm may be willing to take in
relation to level of technological
innovation or advancement was analysed
by Hayes (1985).
Risk and Technology Start-ups
Hayes looked at how big a technical quantum leap
a start-up should take in the technology, issues are:
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The size of the leap will determine the direction, cost and
risk of the technology start-up
If the goals are too ambitious resulting in a wide gap
between the old and new technology and process, this
may result in a weak technical base or inadequate skills to
support such a leap
On the other hand, by aiming for marginal technological
change may reduce the risk exposure but lose the market
to more aggressive competitors.
Risk and Technology Start-ups
Hayes likens the different technology
adoption strategies to the tortoise and the
hare:
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the first method is more logical, predictable and
less risky
the second approach is a technological revolution
strategy, which is very risky
Risk and Technology Start-ups
Hayes comments that:
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US companies do, however, tend to adopt
approaches toward the strategic leap end
US two most powerful competitors, Germany and
Japan, tend to seek incremental improvements
within an existing structure and technology
Risk and Technology Start-ups
The following table presents the different levels of
risk to technology adoption strategy:
Evolutionary
1. Evolutionary – Low risk
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Small dimensional changes

Addition of few standard components
Risk and Technology Start-ups
Incremental
2. Incremental – Moderate risk
 Introduction of one or two significant new inventions, important process
changes, design features
 Addition of major new sub-system
 Significant increase in density of parts, size reduction
3. Incremental – High risk
 Introduction of four or five significant new inventions, major process
changes, design features
 Addition of two or three major new sub-systems
 Major change in materials of several key components
Risk and Technology Start-ups
Revolutionary
4. Revolutionary – Very high risk

Major change in principles of operation

Major change in technology
(The Internet, fiber optics, genetic
engineering, 3-G broadband technology etc.)
Risk and the Project Life Cycle
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The uncertainties associated with a project
decline over its life cycle
the technical uncertainties pertaining to the
viability of the project and the market
uncertainties associated with consumer
acceptance of the project are relatively higher
in the early stages
they decline in later stages of the project
Risk and the Project Life Cycle
The early planning phase is a critical
point in the project life cycle in terms of:
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project feasibility evaluation;
resource allocation, and
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financing strategy
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and this sets the stage for the ensuing
economic performance of the project
Risk and the Project Life Cycle
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the planning stage that requires the least amount
of resources and therefore the lowest risk in the
project life cycle
The development stage has the highest risk
because of the resources committed to the project
against the high level of uncertainties associated
with the project
These uncertainties (risks) will start to diminish as
the project evolves and more information is available
for assessing the technical feasibility of the project
Risk Management Framework
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4 strategies to deal with risks
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Accept
Transfer
Mitigate
Avoid
The application depends on the risk aversion
and experience level of the business.
Risk Management Framework
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Identify the project’s critical/ source of risk exposure;
Quantify the exposure
Assess the impact of the risk exposure
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Strategically (market, HR…)
Financially
Prepare a strategy/plan for resolving each risk;
Monitor and update the risk management, plan, and
results periodically;
Highlight risk-item status in reviews; and
Initiate appropriate corrective actions.
Conclusions
A broad risk identification framework is for
managers and investors to ask the following
questions about a start-up firm:
1.
2.
3.
What do you do to create value?
What can happen to destroy value?
What probability do you assign to the
estimated distribution of outcomes?