Can only wait for the event to happen to see the outcome
Decision
Driven by us, in our control
We decide the outcome, based on knowledge of outcomes
Class of outcomes (event)
Probability of a particular outcome of an event
If the event (class) is allowed to happen a very large number of times, the fraction of the total number of incidents in which the result is a particular outcome is the probability of that outcome
Mangoes cost 120Rs. (per dozen). Of our purchase done in one single lot, some would go bad and be non-saleable. If weather is unsuitable (5% probability) almost 50% go bad. Most probably (90%probability) around 10% of the quantity will go bad. Otherwise, only if we are very lucky (balance 5%), just 1% will go bad. Then, as we sell them over the three month season, in the first month, they will sell most probably (80% chance) at a price of 200Rs. But depending on unexpected fierce competition, it could just be Rs.150. In the second month, the market stabilizes (90% chance) to a price of Rs.160, with excessive competition possibly driving it to Rs. 130. What is the “risk” of the decision to buy 100 dozen for sale?
The risk of price change due to the unique circumstances of a specific security, as opposed to the overall market.
Virtually eliminated in a diversified portfolio
Investors only get rewarded for taking on systematic risk. Unsystematic risk can be diversified away, so the market does not offer higher return for taking it on.
Expected return on security R security = R f + m + ε
A manager of a factory making product B has to decide to invest in development for a new product - product A or product C. She cannot do both due to budget constraints. Product A is estimated to require two million dollars of R&D investment, but only has a 50% chance of the research being successful and a product being obtained. It will have a 30% chance of selling $5M profit, a 40% chance of selling $10M profit, and a 30% chance of no sales. Product C, on the other hand, will also cost $2M in R&D but has an 80% chance of selling $5M profit and a 20% chance of no sales. $1M is the manufacturing cost for either product.
Drivetek Inc. is evaluating a tender for a fee of $250,000 offered for the best proposal for developing the new storage device. Management estimates a cost of $50,000 to prepare a proposal with a fifty-fifty chance of winning the contract. However, DriveTek's engineers have two alternative approaches for building the product. The first approach is a mechanical method with a cost of $120,000. A second approach involves electronic components and will cost only $50,000 to develop a model, but with only a 50 percent chance of satisfactory results.
There are two major decisions in the DriveTek problem. First, the company must decide whether or not to prepare a proposal. Second, if it prepares a proposal and is awarded the contract, it must decide which of the two approaches to try to satisfy the contract.
Jet engine manufacturer considers a project with expected cash flows as discussed in Ross et al Sec. 8.2 page 214 (all values in M$).
Initial investment I = 1500, depreciated on a straight-line basis over 5 years, so yearly depreciation = 300
Revenues in years 1to5 of 6000 (market size S 10000 units, market share M 30%, unit price of 2), variable cost V 3000 (unit cost 1), and annual fixed cost F=1791
Corporate tax rate of 34% , and appropriate discount rate of 15%
Output = NPV= ((M*S*(P-U) - F)*(1-T) + T*I/5) * A 5,15% - I
Input factors :
Market Share M
Size of Market S
Price per Engine P.
Variable unit cost U
Fixed Cost (per period) F
Investment I
List Pessimistic, Realistic and Optimistic values for each input factor.
Create a table of NPV’s with each input factor in turn allowed to take on its range of values, keeping all other factors at their realistic value
The degree to which a project relies on fixed costs
Degree of operating leverage = % change in OCF relative to % change in quantity sold
DOL = 1 + (FC/OCF)
FC=Fixed cost, OCF=Operational Cash Flow
Eg. If OCF is Rs.30,000 for 14000 units and FC=Rs. 40,000, DOL = 1 + (40,000/30,000) =2.333. Thus a 1% increase in units sold would generate a 2.33% increase in OCF in the base case range. Vice versa, a 1% decrease in sales = 2.33% decrease in OCF.
E(R i ) is the expected return on the capital asset
R f is the risk-free rate of interest
As the arithmetic average of historical risk free rates of return and not the current risk free rate of return
R m is the expected return on the market portfolio
β im , “ beta coefficient” is the sensitivity of the asset returns to market returns (R market – R riskfree ) is sometimes known as the market premium or risk premium (the difference between the expected market rate of return and the risk-free rate of return)
R m is the expected return of the market the expected market rate of return is usually measured by looking at the arithmetic average of the historical returns on a market portfolio
What does Beta mean or imply?
A beta of 1 implies the asset has the same systematic risk as the overall market
A beta < 1 implies the asset has less systematic risk than the overall market
A beta > 1 implies the asset has more systematic risk than the overall market
'A' an individual sells a residential house on 12.4.2000 for Rs. 25,00,000/-. The house was purchased by him on 5.7.1997 for Rs. 5,00,000/-.
Since 'A' has held the capital asset for less than 36 months, it is a short capital asset for him and its transfer gives rise to short term capital gains.
Quickly enjoy one peg, Wash the bottle and keep it in the sink
Also keep the Black Glass in the cupboard
But still no one is aware of what I did
Becoz I never take a risk
I: But still I think Iyer's daughter's age is not that much
Wife: What are you saying? She is 28 yrs old... like an aged horse
I:(I forgot her age is 28) Oh Oh...
I again take out potatoes out from my black cupboard
But the cupboard's place has automatically changed
I take out the bottle from the rack and quickly enjoy one peg in the sink
Shivaji Maharaj laughs loudly
I keep the rack in the potatoes & wash Shivaji Maharaj's photo & keep it in the black cupboard Wife is keeping the sink on the stove But still no one is aware of what I did Becoz I never take a risk
I: (getting angry) you call Mr. Iyer a horse? If you say that again, I will cut your tongue...! Wife: Don't just blabber something, go out and sit quietly...
I take out the bottle from the potatoes Go in the black cupboard and enjoy a peg Wash the sink and keep it over the rack
Wife is giving a smile Shivaji Maharaj is still cooking But still no one is aware of what I did Becoz I never take a risk I: (laughing) So Iyer is marrying a horse!! Wife: Hey go and sprinkle some water on your face... I again go to the kitchen, and quietly sit on the rack Stove is also on the rack.
There is a small noise of bottles from the room outside I peep and see that wife is enjoying a peg in the sink But none of the horses are aware of what I did
Becoz Shivaji Maharaj never takes a risk
Iyer is still cooking. And I am looking at my wife from the photo and laughing…
Be the first to comment