#6 Risk Management

#6 Risk Management - Searching for Relationships Since...

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Fusing the ART, SCIENCE , and TECHNOLOGY of Business. Searching for Relationships Since there is no “bankruptcy risk” ratio, Professor Edward Altman conducted statistical analysis on many ratios to search for the ones which had the highest correlation with a bankruptcy within the following 2 years Most ratios had no clear relation, but a combination of 5 passed the test. These 5 are NEGATIVELY related to distress.
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Fusing the ART, SCIENCE , and TECHNOLOGY of Business. Ratios that Predict. . Altman’s Z-score = The bigger the better 1.2 (Working Capital/total assets) + 1.4 (retained earnings/total assets) + 3.3 (EBIT/total assets) + 0.60 (Market value of equity/total debt) + 1.0 (sales/total assets)
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Fusing the ART, SCIENCE , and TECHNOLOGY of Business. The Altman Z Formula Over a decade later, Altman reviewed the results. American Business had changed a lot in that time. Had the formula , too? The same ratios showed up, but the coefficients had changed Note: The formula did not work well for predicting bankruptcy more than 2 years into the future
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Fusing the ART, SCIENCE , and TECHNOLOGY of Business. Summary A lone ratio doesn’t tell us much “Improvement” in a ratio is relative. creditors love increased liquidity…who might not? what is the trend? Managers are still looking for better ways to measure the sources of value, risk and control
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Fusing the ART, SCIENCE, and TECHNOLOGY of Business. RISK Or. .How to Improve Decision Making Through Risk Assessment and Risk Management
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Fusing the ART, SCIENCE , and TECHNOLOGY of Business. Making Financial Decisions - the Corporate Perspective Managers make choices based on best guesses. Sometimes managers seem to make poor choices. Generally those poor choices are caused by incomplete or erroneous information unexpected developments Financial analysis of a firm requires a decision maker to have relevant, useful information. How deeply must the analysis go and to what extent must an analyst use judgment? The answer is it depends and of course the real question is what does it depend on . – The more important the decision the deeper an analyst should go.
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Fusing the ART, SCIENCE , and TECHNOLOGY of Business. How do Managers define Risk? Risk is “ uncertainty that matters ” (Bodie and Merton). In finance, risk leads to uncertainty about the amount and timing of future cash flows. If the stream of future cash flows is known with certainty then judgment becomes unnecessary. For example, simply choose the investment with the highest IRR. . Since future cash flows are “our best guess” we apply a discount rate to accommodate our inability to know the future. The greater our uncertainty – the greater the discount rate
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#6 Risk Management - Searching for Relationships Since...

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