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Risk and return relationship Lecture 2 Lecture outline 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? Risk presents when the possible outcomes may deviate from the expected outcomes. 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 But remember there is a potential upside otherwise why should anyone take risks? Let’s go an example 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. 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 25 34 16 49 45 14 15 10 41 37 27 10 12 25 49 19 39 13 29 7 23 31 44 39 49 22 14 32 15 15 45 43 33 45 5 13 47 28 22 12 31 6 26 46 23 40 50 29 41 39 9 39 43 40 44 40 13 14 32 7 35 34 34 9 25 20 21 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… 5 6 7 7 9 9 10 10 12 12 13 13 13 14 14 14 15 15 15 16 19 20 20 21 22 22 23 23 23 24 25 25 25 25 26 27 28 29 29 30 30 31 31 31 32 32 32 33 34 34 34 35 37 37 39 39 39 39 40 40 40 41 41 41 42 43 43 44 44 45 45 45 45 46 47 47 49 49 49 50 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 20 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 A population can be measured by its: Central tendency (average performance) Mean Mode Median Dispersion (range of possible outcomes) Range Standard Deviation Variance Mean value (Expected value) The arithmetic mean gives the expected value of a population, denoted as E(X): X x E( X ) N Example: 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) Arithmetic mean is defined by all values in a data set. “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. In the previous example: 10, 11, 12, 14, 14, 50 Mode is 14. Median is 13 So what can we say about the expected P/E? Risk measured by dispersion Range – simplest measure of dispersion The range is the difference between the highest and lowest values in the population. 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 Risk measured by dispersion Variance: 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 Standard deviation The standard deviation of a population is the square root of its variance… x 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… 68% 95% 99.7% 4 3 2 2 3 4 Standard Deviation From The Mean Interpreting the results Expected value = 18.5 Standard deviation = 14.2 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 Note the impact of the outliers in this calculation. 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 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 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 Three typical types of project risks: stand-alone risk, corporate risk and market risk Project stand-alone risk What is the project’s stand-alone risk? Project risk relates to the uncertainty about future operating income (EBIT), How well can we predict operating income? Corporate risk How the project fits in with the current corporate strategy and structure 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 How the market may impact on the project Commodity markets Financial markets Interest rate market Foreign exchange markets An indicator of market risk is BETA. 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 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 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? Regression 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? What if it is not a public company? Find beta of a comparable firm Adjust for leverage level What if there is no comparable company? 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: 1. 2. 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 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 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 A highly risky project may achieve a certain degree of market success, but with considerable costs, such as: longer PLC higher costs lower profit margins loss of market share Risk and Technology Start-ups Factors influencing risk level of technology start-ups: 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: 1. 2. 3. 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: 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: 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: 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 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 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: project feasibility evaluation; resource allocation, and financing strategy and this sets the stage for the ensuing economic performance of the project Risk and the Project Life Cycle 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 4 strategies to deal with risks Accept Transfer Mitigate Avoid The application depends on the risk aversion and experience level of the business. Risk Management Framework Identify the project’s critical/ source of risk exposure; Quantify the exposure Assess the impact of the risk exposure 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?