Cost Estimating and Financial Analysis
Cost Estimating and Financial Analysis ENMA 600
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Date Created: 09/28/15
ENMA 600 Cost Estimation And Financial Analysis Session Six Charles B Daniels Tonight s Agenda Risk Management Homework Assignments Questions and Answers l Tonight s Objectives Clarify ow the stock market functions Understand the meaning and fundamentals of risk return and risk aversion Understand how to measure risk and return for a single asset or a portfolio Understand I ortfolio risk management Understand project and program risk management Explain the capital asset pricing model CAPM Stocks A share of common stock is evidence of ownership in a company Many public companies issues millions of shares of stock therefore one share represents a one millionth share of ownership Companies often issue new shares of stock to raise money without incurring debt l Stocks Stockholders have certain rights Select the management of the firm Share in the firm s profits Vote on major decisions made by the firm I Returns on common StOCk The price of the stock goes up appreciation The rm pays dividends not required Stocks 7 A capital gain is an increase in the value of an asset A realized capital gain occurs when the owner of an asset actually sells it for more than he paid for it 5 Daily Stock Trading Stocks are issued by firms to raise money to operate and improve the firm Stocks are traded daily through the exchange where the company is listed New York Stock Exchange NYSE NASDAQ American Stock Exchange AMEX Markets and Prices Stock prices are established based on what a willing buyer will pay a willing seller per share of stock Factors that affect share prices The expectation of future cash flows Future dividends Stock price appreciation Risk and uncertainty What Direction Will the Stock I Market Take Tomorrow Stock prices will fluxuate Precise price movement is difficult to predict As a result some investors use history as a basis for predicting the future Some use technical analysis Many believe in the Efficient Market Hypothesis EMH Efficient Market Hypothesis EMH Part 1 The Efficient Market Hypothesis evolved in the 19605 from the PhD dissertation of Eugene Fama EMH Stock prices fully reflect all available information about the company No other relevant information exists Contradiction Stock buyers believe that the stocks they are buying are worth more than their purchase rice and stock sellers believe that the stoc 5 they are selling are worth less than they are receiving Source htlpwwwinvestorhomecomemhhtm Efficient Market Hypothesis l EMH Part 2 quotAn 39efficient39 market is de ned as many people trying to maximize pro t by predicting the future direction of individual stocks If markets are efficient and current prices fully reflect all information then buying and selling securities in an attempt to outperform the market will involve chance not skill In an ef cient market the actual price of a stock at any time will be a good estimate of its intrinsic value Source htlpwwwinvestorhomecomemhhtm EMH Forms The quotWeakquot form asserts that all past market prices and data are fully re ected in securities prices In other words technical analysis is of no use The quotSemistrongquot form asserts that all publicly available information is fully reflected in securities prices In other words fundamental analysis is of no use The quotStrongquot form asserts that all information is fully reflected in securities prices In other words even insider information is of no use Source htlpwwwinvestorhomecomemhhtm Market History 392 200 Average Annual Return 1 Investment LargeCompany Stocks 2 3 SmallCom any Stocks 174 LongTerm Corporate Bonds 62 LongTerm Government Bonds 58 US Treasury Bills 38 31 Inflation Historical Data For NYSE Composite Index Symbol NYA Closing Price 12311965 6162006 E HiSTORiCALDAlAFOR sts coMPosirE iNDExvaBoLNvAcLosiNG PRiCE 1231mm mi1957 mman l Return Defined Return represents the total gain or loss on an investment kt the actual required or expected return during period t Pt the current price Ptl is the price during the previous time period Ct is any cash flow accruing from the investment 1 Pt 39Pt1 Gt Ptl P51 Rate of Return Problem 51 Rate of Return ktP7P1C P171 LG 1 Rate of Return a 210007 20000 1500 20000 Investment X Retum 1250 55000 7 55000 6800 55000 Investment Y Retum 1236 b Investment X should be selected because it has a higher rate of return for the same level of risk P52 Rate of Return it a1 A 100 800 1100 B 15000 120000 118000 0 7000 45000 48000 D 80 600 500 E 1500 12500 12400 as A 300 100 2500 B 2000 15000 1083 0 3000 7000 2222 D 100 80 333 E 100 1500 1120 Risk Risk Defined In the context of business and finance risk is defined as the chance of suffering a financial loss Assets real or financial which have a greater chance of loss are considered more risky than those with a lower chance of loss Risk Uncertainty Sources of Risk Firm Specific Business Risk Financial Risk Shareholder Specific Risks Interest Rate Risk Liquidity Risk Market Risk Firm and Shareholder Risks Environmentall Event Risk Exchange Rate Risk Purchasing Power Risk Risk Risk Preferences E a 2 RiskgtAverse i Aversei f 2 u 3 5 Indifferent Risklndilferenl I P 1 Seekingi v 3 RiskSeeking 3 3 0 Xi X2 Comparing Risky Ventures Norman Company a custom golf equipment manufacturer wants to choose the better of two investments A and B Each requires an initial outlay of 10000 and each has a most likely annual rate of return of 15 Management has made pessimistic and optimistic estimates of the returns associated with each The three estimates for each assets along with its range is given in the next slide Which asset appears to be less risky Norman Company Example 5 i 390 007 Amara We E m 1L mos may 39 9 a I Discrete Probability Distributions 60 V50 40 20 10 05913172125 05913172125 Return 1 Return Asset B Probability of Occurrence b 0 Probability of Otcurrenze N t O SI Continuous Probability Distributions Z 390 5 a Asset A E 3 Asset B a 2 E A l 15 7 91113151719212325 Retum o Risk Measurement Expected Return Risk Measurement Standard Deviation The most comu acoustical indicator of an asset s risk is the standard deviation 0k which measures the dispersion around the expected value The expected value of a return k bar is the most likely return of an asset F gtkfgtltl r 52 71 where 19 return39for the ith outcome Pr probability of otcurrence of the id outcome 71 number of outcomes considered Standard Deviation The expression for the standard deviation of returns 0k is given in Equation 53 below 5 ii when 39 abilities are often available Calculating Standard Deviation rm E M on Mr Elms 3 A Levers Risk Management Standard Deviation n s m Risk Measurement Standard Deviation 541 54 WA 6526 Normal Distribution Risk Measurement Coefficient I of Variation The coef cient of vara on C is a measure of relative dispersion that is useful in comparing risks of assets with differing expected returns E uation 54 ives the ex ression of the coefficient of variation cv akR Coefficient of Variation When the standard deviation and the expected returns from our example are substituted into Equation 54 the coefficients of variation may be calculated resulting in the values below Asset A Asset B 1 Expected Return 1 20 200 2 Standard Deviation 90 100 3 Coefficient of Variation 21 57 94 Portfolio Risk An investment ortfolio is any collection or combination of inancial assets If we assume all investors are rational and therefore risk averse that investor will ALWAYS choose to invest in portfolios rather than in single assets Investors will hold I ortfolios because the will diversify away a portion of the risk that is inherent In putting all your eggs in one basket A diversi ed portfolio of assets spreads risk where Portfolio Return and Standard Deviation The return of a portfolio is a weighted average of the returns on the individual assets from which it is formed Iw Xklllwzgtltkzl wgtltk r fluxk 55 71 l w proportion of the portfolio s total dollar value represented by asser lei return on assetf Portfolio Return and Standard Deviation Assume that we wish to determine th expected value and standard deviation of returns for ortfolio XY created by combining equal portions 5 of assets X and Y The expected returns of assets X and Y for each of the next 5 years are given in columns 1 and 2 respectively in part the following table In column 3 the weights of 50 for both assets X and Y along with their respective returns from columns 1 and 2 are substituted into equation 55 Column 4 shows the results of the calculation an expected portfolio return of 12 Portfolio Risk Expected Portfolio Returns mam Maxim l A GEL r 1 2004 mm mm was 1 51 W quot a Portfolio Risk Expected Value of Portfolio returns 20042008 K 1200 1200 12 o 12 o 12 o oo 1200 5 5 Perfeclly Positively Correlated Return Portfolio Risk Diversi cation is enhanced depending upon the extent to which n assets move together Portfolio correlation n 3 N E M Perfectly Negativer Correlaled N M Time Time Portfolio Risk Even if two assets are n rerfectly negatively correlated an investor can still realize diversification benefits from combining them in a portfolio as shown in the gure below rtfolia of 9 F Assets V Assels Fanier Relurn Return Relurn gtH Portfolio Risk W i value miraan 3 Correlation Return and Risk for TwoAsset Portfolios D inf i J tmiimmomm gmxaaamamima Q maizerarlmusaam m eraiomeaam wan I Giiemls oi mo urmmaztmll mm W mama a V gamma quot 11 i wm m mg W mam Diversification USA Markets Portfolio Risk SD Unsystematic diversifiable Risk 0M Systematic nondiversifiable Risk o of Stocks gr Diversification Worldwide Portfolio Risk SD 0M Portfolio of Domestic Assets Only Portfolio of both Domestic and International Assets of Stocks Capital Asset Pricing Model CAPM Some portfolio s risk the standard deviation of returns can be eliminated simply by holding a lot of stocks Some risk cannot be eliminated by adding stocks systematic because that variability is caused by events that the entire market Examples would include changes in macroeconomic factors such interest rates inflation and the business cycle Capital Asset Pricing Model I CAPM In the early 19605 nance researchers Sharpe Treynor and Lintner developed an asset pricing model that measures only the amount of systematic risk a particular asset has They observed that not all stock movement is linear and not all stocks are perfectly correlated to the market They reasoned that if they could measure this variability the systematic risk then they could develop a model to price assets using only this risk The unsystematic companyrelated risk is irrelevant because it could easily be eliminated simply by diversifying Capital Asset Pricing Model CAPM To measure the amoun o systematic risk an asset has they simply regressed the returns for the market portfolio the portfolio of ALL assets against the returns for an individual asset The slope of the regression line beta measures an asset s systematic nondiversifiable risk In general cyclical companies like auto companies have high betas while relatively stable companies like public utilities have low betas 252mmme I An 2 mmmwaxsrrJanas mm mmw mmu I mamwama gym4 l 39 wl xuwmm 153139 1 z A wmmaammf IAIdVID 5 lepow 5U3Jd lBSSV lendea mmumaaammszam U xmnwuwqmmanuwm pm awn awryAnti 5 Ian lmup 1 mm W I quot4 quot Isa mam my 2399 5 I Beta Values of Public Companies AES Corp Amazoncom Anheuser Busch Citigroup Disney eBay ExxonMobile General Electric GE Google IBM Intel Merrill Lynch Microsoft NIKE Pepsico Qualcomm Sempra Energy Southwest Airlines Beta Values Sorted by Beta JetBlue JBLU Pepsico PEP Wal Mart WMT Sempra Energy SRE Microsoft MSFT Anheuser Busch BUD Citigroup C General Electric GE GE Southwest Airlines LUV KE NKE Google GOOG AES Corp Disney ExxonMobile Merrill Lynch Intel Qualcomm Amazoncom eBay Austin Fund s Porfolio V amp W im mw 3quot ram 3am J M35 lm 395 219 5113 1 Beta for Portfolio V is higher than Portfolio W Porfolio V is riskier Capital Asset Pricing Model CAPM The required return for all assets is composed of two parts the riskfree rate and a risk premium The risk premium is a function of both market conditions and the asset itself The riskfree rate RF is usually estimated from the return on US T bills g Risk Premium l IIIC lle JlCIIIIUlll lUl d bLULK lb composed of two parts The Market Risk Premium which is the return required for investing in any risky asset rather than the riskfree rate Beta a risk coefficient which measures the sensitivity of the particular stock s return to changes in market conditions Capital Asset Pricing Model CAPM After estimating beta which measures a specim asset or portfolio s systematic risk estimates of the other variables in the model may be obtained to calculate an asset or portfolio s required return ki RF bi x km RF where ki an asset39s expected or required return RF the risk free rate of return bi an asset or portfolio39s beta kn1 the expected return on the market portfolio gll CAPM Example Calculate the required return for Federal Express assuming it has a beta of 125 the rate on US Tbills is 5 and the expected return for the SampP 500 is 15 ki RF bix km 39 RF ki 5 125 15 5 ki 175 SML asset s risk premium 125 o Portfolio Beta 391 2mm quot 39o be M m mm SW 5 6 w W F amQTQEE 3 Portfolio Beta Thoughts about CAPM CAPM assumes markets are efficient CAPM relies on historical data which means the betas may or may not actually reflect the future variability of returns Required returns s ecified b the model should be used on y as roug approximations Some studies sug est the existence of the relationship descri ed by the CAPM in active markets eg NYSE Project and Program Risk Management Dealing with Uncertainty I Project and Program Risk Risk and uncertainty are similar in that they both present the problem of unknown future conditions Risk offers estimates of probabilities for possible outcomes Unceltainty does not provide estimates of probabilities for possible outcomes Major Sources Of Uncertainty Inaccurate estimates used to plan the task or project Business conditions recessions growth Changing customer needs expectations and desires Technology changes Duration 5 Possible Inaccuracies How much source information is available How dependable is the source information Uncertainty in capital investment requirements is often reflected as a contingency or reserve above actual costs of the project Risk Disposition Accept the Risk Sometimes a last resort Small probability with catastrophic outcome still equals catastrophic outcome Mitigate the Risk Determine cost of mitigation Mitiation cost should be less than oriinal risk impact Transfer the Risk Subcontracting Outsourcing 5 Risk Quantification 1 2 Identify risk type and priority Determine the probability of occurrence the impact of occurrence and the factored or likely impact probability x impact Risk Quantification 3 4 5 Determine the mitigation plan and the cost of the mitigation plan Determine the probability of occurrence if the mitigation plan is implemented Multiply the new probability by the original impact to obtain the revised impact Add the cost of mitigation and the revised impact to obtain management reserve or contingency funding Risk Management Risk Adjusced EAC Chapter 5 Homework Assignments P53 Risk Preferences 3 u quot lp c 9 I nvestment iReturn x 1 12 10 a The riskindifferent 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 riskaverse manager would accept Investment X because it rowdes the hi hest return and has the lowest amount of risk nvestment X o ers an Increase In return fortaking on more risk than what the firm currently earns c The riskseekin manager would accept Investments Y and Z ecause he or s e is Willing to take greater risk Without an increase in return d Traditionally financial mana ers are riskaverse and would choose estment X since it prOVI es the reqUIred increase in return for an increase in risk I P54 Risk Analysis a Expansion Range A 24 16 8 B 30 10 20 b Project A is less risky since the range of outcomes for A is smaller than the range for Project B c Since the most likely return for both projects is 20 and the initial investments are equal the answer depends on your risk preference dThe answer is no longer clear since it now involves a risk return trade off Project B has a slightly higher return but more risk while A has both lower return and lower risk P59a Assessing Return amp Risk 257 1 Range 110 2 Expected value 45 Kate ot Ketufl39l rronanlllty Weighted Value EXPcued ii LEE kai Pr Return 01 001 0001 01 004 0004 02 005 001 03 01 003 04 015 006 045 03 0135 05 015 0075 06 01 006 0 7 005 0 035 0 8 004 0 032 1 001 0 01 Range 11 11 1 045 045 I P59 Assessing Return amp Risk 257 ki39 k kik we2 3 kiTk2 01 045 055 03025 001 0003025 01 045 035 01225 004 00049 02 045 025 00625 005 0003125 03 045 015 00225 01 000225 04 045 005 00025 015 0000375 0 05 045 005 00025 015 0000375 045 015 00225 01 000225 07 045 025 00625 005 0003125 0 45 035 01225 004 00049 1 045 055 03025 001 0003025 3 Standard Deviation cmm 257 quot0027350 2 0165378 4 Coefficient of 0165378 Variation CV W 03675 P59a Assessing Return amp Risk 432 1 Range 50 10 40 2 Expected value 30 Rate of Weighted Expectedquot R tiii39h Prbbab ilit x Valu39e 39 R ii k Eri ki XJ n 10 0050 0 005 15 0100 0 015 20 0100 u um 25 0150 0 038 30 0200 0 060 35 0150 0 053 40 0100 0 040 45 0100 0 045 50 0050 0025 1 30 0 3 Assessing Return amp Risk 257 0 15 0 0225 0 0 00225 02 03 01 001 01 0001 025 03 005 00025 015 0000375 03 03 0 0 02 035 03 005 00025 015 0000375 04 03 01 001 01 0001 045 03 015 00225 01 000225 05 03 02 004 005 0002 001125 3 Standard Deviation smeam 0011250 0106066 4 Coefficient of CV7 0106066 Variation 0300 03536 Project 257 Probabilities of Rate of Return Probability o a 10 10 20 30 40 45 50 60 70 80 100 Rate of Return Project 432 Probabilities of g Rate of Return 03 Probability 10 15 20 25 30 35 40 45 50 Rate of Return P59c Summary Since Projects 257 and 432 have differing expected values the coefficient of variation should be the criterion by which the risk of the asset is judged Since Project 432 has a smaller CV it is the opportunity with lower risk 9 ro39 c t32is7 Pquotr039efct432 Range 110 40 Expected Return 45 30 Standard Deviation 165 106 Coefficient of Variation 03675 03536 l P521 Portfolio Beta EASS I B ta WA WAX b39A W3 W3 X b3 1 130 010 0130 030 039 2 070 030 0210 010 007 3 125 010 0125 020 025 4 110 010 0110 020 022 5 090 040 0360 020 018 bA 0935 bb 111 Portfolio A is slightly less risky than the market average risk while Portfolio B is more risky than the market Portfolio B s return will move more than Portfolio A s for a given increase or decrease in market return Portfolio B is the more risky Problem 522 Lapnal Asset Pricing Mouel CAPM Kj K 1 Dj x Km RF Case kj RF b X km RF A 89 5 130 x8 5 B 125 8 090 x13 8 C 84 9 020x129 D 150 10 100 x1510 E 84 6 060 x10 6 ki RF bi X 39 RF Where ki an asset39s expected or required return RF the risk free rate of return bi an asset or portfolio39s beta kquotI the expected return on the market portfolio P529 Ethics situa ion One may gain insight into the moralethical framework within which deCISIOnS are made Another approach is to use a pencilandpaper honest test these are surpri5ingly accurate despite the obVIous notion t at the Job candidate may a em ame the exam y givmg the right versus the In iVIdually accurate responses Before even administering the situational interview question or the test ask the candidate to list the preferred attributes of the type of company he or she aspires to workfor and see if character and ethics terms emerge in the description Some companies do credit history checks after gaining the candidates approval to do so Usin all four of these techniques allows one to triangulate toward a va id and defenSIble appraisal ofa candidate s honesty and integr39ty One itvay is to ask how the candidate would handle a hypothetical Assignments for Next Session Read Chapter 6 Interest Rates and Bond Valuation Read Chapter 7 Stock Valuation Work Problems P6 1 P6 2 P6 7 P6 8 P6 13 p6 16 P6 27 P7 1 P7 2 P7 5 P7 7 P7 9 P7 11 P7 14 P7 18 P7 23 P7 24 Cha ter 6 Case Stud Eiauatn Annie He is Proposed In iestment 7 Atiier Industries Bonds Chapter 7 Case Study Assessing the 1m act p of Suarez Manufacturing is Proposed Risky In iestment on its Stock Iaue