case1_06

case1_06 - Case 1 Risk and Rates of Return Universiteit...

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Case 1 Risk and Rates of Return Universiteit Maastricht Faculty of Economics and Business Administration Maastricht, November 5th, 2006 Safar Al-Halabi, Anas ID: 222518 Students International Business Studies Course code: 3020B Tutor: G. Hubner 1
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Introduction Managers and Investors often have different perception when it comes to risk. Not only do they have different risk awareness but they also different approaches to evaluate risk of specific projects and investments, while managers tend to focus more on long term investments, investors normally look out for quick gains. The difference between investors and managers brings a number of implications for the managers. They have to take in account the investors perspective to understand how the market will react on the company’s strategy. In this case we will explain the different risk perceptions by answering the given questions. Question 1. a) The main risk factor for stock prices is the volatility of the market price. Thus the large difference between high and low returns suggests a high variance and thus a high standard deviation, which is the measurement of risk. According to this reasoning stocks with a wide spread between high and low returns can be interpreted as a relatively risky investment. b) The investment horizon and riskiness of utility monopolies are similar to government investments such as schools or roads which are paid by taxes in the long run. Thus the securities issued by these companies in the ‘good old days’ could be compared to T-Bonds and T-Bills. The competitive situation nowadays which affects the profitability of utility providers will be increase volatility in the returns. However, demand for electricity is inelastic to the state of economic similar to the food industry. c) Companies are normally very conservative in their dividend policy and the dividend yield is generally predictable and independent of the current market situation. In this sense, the dividend payout ratio normally does not have an effect on the riskiness of a stock as risk is the result of unexpected change and dividend is stable and must be announced beforehand. d) As visible in Table 1 in the case, in all states of the economy the expected return of the t- bills is 5%. The variance to the mean is obviously zero as well as the standard deviation. This would imply it is a riskless asset which is independent of the state of economy. e) T-Bonds are level coupon bonds with a long maturity. They pay a fixed interest on fixed times a year. To calculate the value of a T-Bond both the coupon payments and the principal have to be discounted. A change in the state of the economy and thus a change in the interest rate can alter the value of a bond. In a booming economy the expected return on bonds is low compared to stocks since the interest rate is likely to rise. During a recession the interest rates tends to be low which would mean a higher price of the bond and thus a higher expected return. Bonds issued by NCU have a slightly higher payoff than Treasury Bonds as firms in 2
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general have a higher default risk than governments. The bond rating of a company usually
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case1_06 - Case 1 Risk and Rates of Return Universiteit...

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