REVIEW QUESTIONS

8–1 What is risk in the context of financial decision making?

Risk is defined as the chance of financial loss, as measured by the variability of expected returns
associated with a given asset. A decision maker should evaluate an investment by measuring
the chance of loss, or risk, and comparing the expected risk to the expected return. Some assets
are considered risk-free; the most common examples are U. S. Treasury issues.

8–2 Define return, and describe how to find the rate of return on an investment.
The return on an investment (total gain or loss) is the change in value plus any cash distributions
over a defined time period. It is expressed as a percent of the beginning-of-the-period
investment. The formula is:

Realized return requires the asset to be purchased and sold during the time periods the return
is measured. Unrealized return is the return that could have been realized if the asset had been
purchased and sold during the time period the return was measured.

8–3 Compare the following risk preferences: (a) risk averse, (b) risk neutral,
and (c) risk seeking. Which is most common among financial managers?
a. The risk-averse financial manager requires an increase in return for a given increase in risk.
b. The risk-indifferent manager requires no change in return for an increase in risk.
c. The risk-seeking manager accepts a decrease in return for a given increase in risk.
Most financial managers are risk-averse.

8–4 Explain how the range is used in scenario analysis.

Sensitivity analysis evaluates asset risk by using more than one possible set of returns to obtain
a sense of the variability of outcomes. The range is found by subtracting the pessimistic
outcome from the optimistic outcome. The larger the range, the more variability of risk
associated with the asset.

8–5 What does a plot of the probability distribution of outcomes show a

decision maker about an asset’s risk?

The decision maker can get an estimate of project risk by viewing a plot of the probability
distribution, which relates probabilities to expected returns and shows the degree of dispersion
of returns. The more spread out the distribution, the greater the variability or risk associated
with the return stream.

8–6 What relationship exists between the size of the standard deviation and
the degree of asset risk?

The standard deviation of a distribution of asset returns is an absolute measure of dispersion

of risk about the mean or expected value. A higher standard deviation indicates a greater
project risk. With a larger standard deviation, the distribution is more dispersed and the
outcomes have a higher variability, resulting in higher risk.

8–7 What does the coefficient of variation reveal about an investment’s risk
that the standard deviation does not?
The coefficient of variation is another indicator of asset risk, measuring relative dispersion. It is
calculated by dividing the standard deviation by the expected value. The coefficient of variation
may be a better basis than the standard deviation for comparing risk of assets with differing
expected returns.

8–8 What is an efficient portfolio? How can the return and standard deviation
of a portfolio be determined?

An efficient portfolio is one that maximizes return for a given risk level or minimizes risk for a
given level of return. Return of a portfolio is the weighted average of returns on the individual
component assets:

Where n = number of assets, wj = weight of individual assets, and = expected jkˆ

Returns.
The standard deviation of a portfolio is not the weighted average of component standard
deviations; the risk of the portfolio as measured by the standard deviation will be smaller. It is
calculated by applying the standard deviation formula to the portfolio assets:

8–9 Why is the correlation between asset returns important? How does
diversification allow risky assets to be combined so that the risk of the
portfolio is less than the risk of the individual assets in it?

The correlation between asset returns is important when evaluating the effect of a new asset
on the portfolio's overall risk. Returns on different assets moving in the same direction are
positively correlated, while those moving in opposite directions are negatively correlated.
Assets with high positive correlation increase the variability of portfolio returns; assets with
high negative correlation reduce the variability of portfolio returns. When negatively correlated
assets are brought together through diversification, the variability of the expected return from
the resulting combination can be less than the variability or risk of the individual assets. When
one asset has high returns, the other's returns are low and vice versa. Therefore, the result of
diversification is to reduce risk by providing a pattern of stable returns.
Diversification of risk in the asset selection process allows the investor to reduce overall risk by
combining negatively correlated assets so that the risk of the portfolio is less than the risk of
the individual assets in it. Even if assets are not negatively correlated, the lower the positive
correlation between them, the lower the resulting risks.
8–10 How does international diversification enhance risk reduction? When
might international diversification result in subpar returns? What are
political risks, and how do they affect international diversification?

The inclusion of foreign assets in a domestic company's portfolio reduces risk for two reasons.
When returns from foreign-currency-denominated assets are translated into dollars, the
correlation of returns of the portfolio's assets is reduced. Also, if the foreign assets are in
countries that are less sensitive to the U.S. business cycle, the portfolio's response to market
movements is reduced.

When the dollar appreciates relative to other currencies, the dollar value of a foreign-currency-
denominated portfolio declines and results in lower returns in dollar terms. If this appreciation
is due to better performance of the U.S. economy, foreign-currency-denominated portfolios
generally have lower returns in local currency as well, further contributing to reduced returns.

Political risks result from possible actions by the host government that are harmful to foreign
investors or possible political instability that could endanger foreign assets. This form of risk is
particularly high in developing countries. Companies diversifying internationally may have
assets seized or the return of profits blocked.

8–11 How are total risk, nondiversifiable risk, and diversifiable risk related?
Why is nondiversifiable risk the only relevant risk?

The total risk of a security is the combination of nondiversifiable risk and diversifiable risk.
Diversifiable risk refers to the portion of an asset's risk attributable to firm-specific, random
events (strikes, litigation, loss of key contracts, etc.) that can be eliminated by diversification.

Nondiversifiable risk is attributable to market factors affecting all firms (war, inflation, political
events, etc.). Some argue that nondiversifiable risk is the only relevant risk because diversifiable
risk can be eliminated by creating a portfolio of assets which are not perfectly positively
correlated.

8–12 What risk does beta measure? How can you find the beta of a portfolio?

Beta measures nondiversifiable risk. It is an index of the degree of movement of an asset's

return in response to a change in the market return. The beta coefficient for an asset can be
found by plotting the asset's historical returns relative to the returns for the market. By using
statistical techniques, the "characteristic line" is fit to the data points. The slope of this line is
beta. Beta coefficients for actively traded stocks are published in Value Line Investment Survey
and in brokerage reports. The beta of a portfolio is calculated by finding the weighted average
of the betas of the individual component assets.
8–13 Explain the meaning of each variable in the capital asset pricing model
(CAPM) equation. What is the security market line (SML)?

The equation for the Capital Asset Pricing Model is: kj = RF+[bj x (km - RF)],
Where:
kj = the required (or expected) return on asset j.
RF = the rate of return required on a risk-free security (a U.S. Treasury bill)
bj = the beta coefficient or index of nondiversifiable (relevant) risk for asset j
km = the required return on the market portfolio of assets (the market return)
The security market line (SML) is a graphical presentation of the relationship between the
amount of systematic risk associated with an asset and the required return. Systematic risk is
measured by beta and is on the horizontal axis while the required return is on the vertical axis.

8–14 What impact would the following changes have on the security market
line and therefore on the required return for a given level of risk? (a) An
increase in inflationary expectations. (b) Investors become less riskaverse.
a. If there is an increase in inflationary expectations, the security market line will show a
parallel shift upward in an amount equal to the expected increase in inflation. The required
return for a given level of risk will also rise.
b. The slope of the SML (the beta coefficient) will be less steep if investors become less risk-
averse, and a lower level of return will be required for each level of risk.

P8–1 Rate of return Douglas Keel, a financial analyst for Orange Industries, wishes to
estimate the rate of return for two similar-risk investments, X and Y. Douglas’s
research indicates that the immediate past returns will serve as reasonable estimates
of future returns. A year earlier, investment X had a market value of $20,000;
investment Y had a market value of $55,000. During the year, investment X generated
cash flow of $1,500 and investment Y generated cash flow of $6,800. The current
market values of investments X and Y are $21,000 and $55,000, respectively.
a. Calculate the expected rate of return on investments X and Y using the most
recent year’s data.
b. Assuming that the two investments are equally risky, which one should Douglas
recommend? Why?
8-3. Risk preferences Sharon Smith, the financial manager for Barnett Corporation,
wishes to evaluate three prospective investments: X, Y, and Z. Sharon will evaluate
each of these investments to decide whether they are superior to investments that her
company already has in place, which have an expected return of 12% and a standard
deviation of 6%. The expected returns and standard deviations of the investments
are as follows:

a. If Sharon were risk neutral, which

investments would she select? Explain why.
b. If she were risk averse, which investments
would she select? Why?
c. If she were risk seeking, which
investments would she select? Why?
d. Given the traditional risk preference
behavior exhibited by financial managers,
which investment would be preferred? Why?

5-3 LG 1: Risk Preferences

a. The risk-indifferent manager would accept Investments X and Y because these have higher
returns than the 12% required return and the risk doesn’t matter.
b. The risk-averse manager would accept Investment X because it provides the highest return
and has the lowest amount of risk. Investment X offers an increase in return for taking on more
risk than what the firm currently earns.
c. The risk-seeking manager would accept Investments Y and Z because he or she is willing to
take greater risk without an increase in return.
d. Traditionally, financial managers are risk-averse and would choose Investment X, since it
provides the required increase in return for an increase in risk.
P8–4 Risk analysis Solar Designs is considering an investment in an expanded product
line. Two possible types of expansion are being considered. After investigating the
possible outcomes, the company made the estimates shown in the following table.

a. Determine the range of the

rates of return for each of
the two projects.
b. Which project is less
risky? Why?
c. If you were making the
investment decision, which one
would you choose? Why?
What does this imply about
your feelings toward risk?
d. Assume that expansion B’s
most likely outcome is 21% per
year and that all other facts
remain the same. Does this
change your answer to part c?
Why?

P8–5 Risk and probability Micro-Pub, Inc., is considering the purchase of one of two
microfilm cameras, R and S. Both should provide benefits over a 10-year period, and
each requires an initial investment of $4,000. Management has constructed the
accompanying table of estimates of rates of return and probabilities for pessimistic,
most likely, and optimistic results.
a. Determine the range for the rate of return for each of the two cameras.
b. Determine the expected value of return for each camera.
c. Purchase of which camera is riskier? Why?
c. Camera S is considered more risky than Camera R because it has a much broader range of
outcomes. The risk-return trade-off is present because Camera S is more risky and also provides
a higher return than Camera R.

P8–7 Coefficient of variation Metal Manufacturing has isolated four alternatives for
meeting its need for increased production capacity. The following table summarizes
data gathered relative to each of these alternatives.

a. Calculate the coefficient of variation for each alternative.

b. If the firm wishes to minimize risk, which alternative do you recommend? Why?
Standard deviation versus coefficient of variation as measures of risk Greengage,
Inc., a successful nursery, is considering several expansion projects. All of the
alternatives promise to produce an acceptable return. Data on four possible projects
follow.

a. Which project is least risky, judging on the basis of range?

b. Which project has the lowest standard deviation? Explain why standard deviation
may not be an entirely appropriate measure of risk for purposes of this comparison.
c. Calculate the coefficient of variation for each project. Which project do you
think Greengage’s owners should choose? Explain why.

6
REVIEW QUESTIONS
15–1 Why is working capital management one of the most important and
time-consuming activities of the financial manager? What is net working
capital?

Short-term financial management, the management of the firm's current assets and liabilities,
is one of the financial manager's most important functions. Managing these accounts wisely
results in a balance between profitability and risk that has a positive impact on the firm's
value.Therefore, managing these current balance sheet accounts to achieve an appropriate
balance between
profitability and risk takes a large amount of a financial manager's time.

The basic definition of net working capital is the difference between current assets and current
liabilities. An alternative definition is that portion of current assets financed by long-term
funding (when current assets exceed current liabilities-positive working capital) or that portion
of the firm's fixed assets financed with current liabilities (when current assets are less than
current liabilities-negative working capital).

15–2 What is the relationship between the predictability of a firm’s cash

inflows and its required level of net working capital? How are net
working capital, liquidity, and risk of insolvency related?

The more predictable a firm's cash inflows, the lower the level of net working capital with
which it can safely operate. This is true since the more predictable or certain the receipt of cash
inflow, the less cushion (i.e., net working capital) needed to absorb unexpected funds
requirements. The higher a firm's net working capital, the higher its liquidity may be, since
more current assets are available to provide for payment of short-term obligations. However, if
current assets are predominantly illiquid inventories or prepaid expenses, liquidity may not be
improved with higher net working capital. Also, positive net working capital is financed with
long-term funds which are usually more costly and can place more constraints on the firm's
operations.

Risk of insolvency is the probability that a firm is unable to meet its payment when due
Technical insolvency occurs if a firm is unable to meet its payments when due. Generally, the
higher the firm's net working capital, the lower the risk of insolvency. Increasing net working
capital indicates increased liquidity and therefore a decreased risk of insolvency, and vice versa.

15–3 Why does an increase in the ratio of current assets to total assets
decrease both profits and risk as measured by net working capital? How
do changes in the ratio of current liabilities to total assets affect profitability
and risk?
If a firm increases the ratio of current-to-total assets, it will have a larger proportion of current
assets.
Because current assets are less profitable, overall profitability will decrease. The firm will have
more net working capital (due to increased current assets), lower risk of technical insolvency,
and also may have greater liquidity. It is also important to consider the composition of current
assets. The "nearer" a current asset is to cash, the greater its liquidity may be and the lower its
risk. For example, an investment in accounts receivable is less risky than inventory.

The higher the ratio of current liabilities to total assets, the more current liabilities in relation to
long-term funds held by the firm. Since in most economic conditions, current liabilities are a
cheaper form of financing than long-term funds, the reduced financing costs should increase
the firm's profits. At the same time, the firm has less net working capital, thereby reducing
liquidity and increasing the risk of technical insolvency. A decrease in the ratio would increase
both profits and risk.

15–4 What is the difference between the firm’s operating cycle and its cash

conversion cycle?

A firm's operating cycle is the period when a firm has its money tied up in inventory and
accounts
receivable until cash is collected from the sale of the finished product. It is calculated by adding
the
average age of inventory (AAI) to the average collection period (ACP). The cash conversion cycle
(CCC) is the number of days in the firm's operating cycle (OC) minus the average payment
period (APP) for inputs to production. The CCC takes into account the time at which payment is
made for material; this spontaneous form of financing partially or fully offsets the need for
negotiated financing while resources are tied up in the operating cycle.

15–5 Why is it helpful to divide the funding needs of a seasonal business into
its permanent and seasonal funding requirements when developing a
funding strategy?

If a firm does not face a seasonal cycle then they will face only a permanent funding
requirement. With seasonal needs the firm must also make a decision as to how they wish to
meet the short-term nature of their seasonal cash demands. They may choose either an
aggressive or conservative policy toward this cyclical need.

15–6 What are the benefits, costs, and risks of an aggressive funding strategy
and of a conservative funding strategy? Under which strategy is the borrowing
often in excess of the actual need? An aggressive strategy finances a firm's seasonal needs, and
possibly some of its permanent needs, with short-term funds, including trade credit as well as
bank lines of credit or commercial paper. This approach seeks to increase profit by using as
much of the less expensive short-term financing as possible, but increases risk since the firm
operates with minimum net working capital, which could become negative.Another factor
contributing to risk is the potential to quickly arrange for long-term funding, which is generally
more difficult to negotiate, to cover shortfalls in seasonal needs.

The conservative strategy finances all expected fund requirements with long-term funds, while
short-term funds are reserved for use in the event of an emergency. This strategy results in
relatively lower profits, since the firm uses more of the expensive long-term financing and may
pay interest on unneeded funds.The conservative approach has less risk because of the high
level of net working capital (i.e., liquidity)which is maintained; the firm has reserved short-term
borrowing power for meeting unexpected fund demands.

15–7 Why is it important for a firm to minimize the length of its cash conversion
cycle?

The longer the cash conversion cycle the greater the amount of investment tied up in low
return assets. Any extension of the cycle can result in higher costs and lower profits.

15–8 What are likely to be the viewpoints of each of the following managers
about the levels of the various types of inventory: finance, marketing,
manufacturing, and purchasing? Why is inventory an investment?

Financial managers will tend to want to keep inventory levels low to reduce financing costs.
Marketing managers will tend to want large finished goods inventories. Manufacturing
managers will tend to want high raw materials and finished goods inventories. The purchasing
manager may favor high raw materials inventories if quantity discounts are available for large
purchases.

Inventory is an investment because managers must purchase the raw materials and make
expenditures for the production of the product such as paying labor costs. Until cash is received
through the sale of the finished goods the cash expended for creation of the inventory, in any
of its forms, is an investment by the firm.

15–9 Briefly describe the following techniques for managing inventory: ABC
system, economic order quantity (EOQ) model, just-in-time (JIT) system,
and computerized systems for resource control—MRP, MRP II, and ERP.
15–10 What factors make managing inventory more difficult for exporters and
multinational companies?

15–11 What is the role of the five C’s of credit in the credit selection activity?

15–12 Explain why credit scoring is typically applied to consumer credit decisions
rather than to mercantile credit decisions.

15–13 What are the basic trade-offs in a tightening of credit standards?

15–14 Why are the risks involved in international credit management more
complex than those associated with purely domestic credit sales?
15–15 Why do a firm’s regular credit terms typically conform to those of its
industry?

15–16 Why should a firm actively monitor the accounts receivable of its credit
customers? How are the average collection period and an aging
schedule used for credit monitoring?

15–17 What is float, and what are its three components?

15–18 What are the firm’s objectives with regard to collection float and to
payment float?

15–19 What are the three main advantages of cash concentration?

15–20 What are three mechanisms of cash concentration? What is the objective
of using a zero-balance account (ZBA) in a cash concentration
system?
15–21 What two characteristics make a security marketable? Why are the
yields on nongovernment marketable securities generally higher than
the yields on government issues with similar maturities?