Lecture21-2004 - Lecture XXI Applications of Stochastic...

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1 Lecture XXI Applications of Stochastic Dominance I. Moss, Charles B., Stephen A. Ford, and Mario Castejon “Effect of Debt Position on the Choice of Marketing Strategies for Florida Orange Growers: A Risk Efficiency Approach.” Southern Journal of Agricultural Economics (1991): 103–11. A. The risk of a firm can be decomposed into business risk and financial risk. 1. Business risk is the risk inherent in the production/business environment. 2. Financial risk results from the leverage (debt) decisions based on that business environment. 3. Collins (1985) demonstrated this decomposition using a DuPont expansion: 1 p E r iK A R δ  +−   = where E R is the rate of return to equity, p r is the return to production activities, A is the total level of output, i is the rate of capital gains, is the debt-to-asset position, and K is the cost of debt capital. a. Following this development, 2 p A A r Ri A σ =+ b. Therefore, the expected rate of return on equity and the variance of the rate of return on equity can be derived as: () 2 2 2 , 1 1 AA EE K µδ µσ == assuming that the cost of debt is non-stochastic. B. The linkage between debt and asset returns has been addressed several ways in economic literature.
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Lecture21-2004 - Lecture XXI Applications of Stochastic...

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