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©2012 McGraw-Hill Ryerson Limited1 of 31
Learning Objectives
1. Describe the concept of risk based on the uncertainty of future cash flows. (LO1)
2. Characterize most investors as risk averse. (LO2)
3. Analyze risk as standard deviation, coefficient of variation or beta. (LO3)
4. Integrate the basic methodology of risk-adjusted discount rates for dealing with risk in capital budgeting analysis. (LO4)
©2012 McGraw-Hill Ryerson Limited2 of 31
Statistical Measurements of Risk
Expected Value: D– weighted average of possible outcomes (forecasts) times their
probabilities– the most likely forecast (best estimate)
Standard Deviation: σ– measure of dispersion or variability around the expected value– measure of the spread of possible outcomes– larger the standard deviation greater the risk
Coefficient of Variation: V
– standard deviation / expected value– allows comparison of investments of different sizes– larger the coefficient of variation greater the risk
LO3
©2012 McGraw-Hill Ryerson Limited3 of 31
Figure 13-3Probabilitydistribution withdiffering degreesof risk
LO3
©2012 McGraw-Hill Ryerson Limited4 of 31
Which Investment is the Riskiest?
• With the same expected value, the standard deviation is a good measure of risk.
• Investments with quite different expected values, require the coefficient of variation to better measure risk.
LO3
©2012 McGraw-Hill Ryerson Limited5 of 31
Statistical measure of volatility (risk) (covariance/market covariance) measures how responsive or sensitive a company’s stock is to
market movements in general
An individual stock’s beta shows how risky it compares to the market as a whole:– beta = 1 means equal risk with the market– beta > 1 means more risky than the market– beta < 1 means less risky than the market
Company risk may provide guideline to risk of a new investment in that company
LO3
Risk in a Portfolio
©2012 McGraw-Hill Ryerson Limited6 of 31
Table 13-2Betas, July 2011
LO3
Source: www.reuters.com/finance/stocks http://pages.stern.nyu.edu/~adamovar/New_Home_Page/data.html
Company Name Beta
Bombardier (BBD.bTO)…………………………………………………………. 1.40
Canadian Tire (CTC.TO)…………………………………………………………
0.63
Power Corp. (POW.TO………………………………………………………….. 0.94
Potash Corp. (POT.TO)…………………………………………………………. 1.06
RIM (RIM.TO)…………………………………………………………………….. 1.92
Royal Bank (RY.TO)………………………………………………………….......
0.67