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Learning Objectives

1. Describe the concept of risk based on the uncertainty of future cash flows. (LO1)

2. Characterize most investors as risk averse. (LO2)

3. Analyze risk as standard deviation, coefficient of variation or beta. (LO3)

4. Integrate the basic methodology of risk-adjusted discount rates for dealing with risk in capital budgeting analysis. (LO4)

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Statistical Measurements of Risk

Expected Value: D– weighted average of possible outcomes (forecasts) times their

probabilities– the most likely forecast (best estimate)

Standard Deviation: σ– measure of dispersion or variability around the expected value– measure of the spread of possible outcomes– larger the standard deviation greater the risk

Coefficient of Variation: V

– standard deviation / expected value– allows comparison of investments of different sizes– larger the coefficient of variation greater the risk

LO3

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Figure 13-3Probabilitydistribution withdiffering degreesof risk

LO3

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Which Investment is the Riskiest?

• With the same expected value, the standard deviation is a good measure of risk.

• Investments with quite different expected values, require the coefficient of variation to better measure risk.

LO3

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Statistical measure of volatility (risk) (covariance/market covariance) measures how responsive or sensitive a company’s stock is to

market movements in general

An individual stock’s beta shows how risky it compares to the market as a whole:– beta = 1 means equal risk with the market– beta > 1 means more risky than the market– beta < 1 means less risky than the market

Company risk may provide guideline to risk of a new investment in that company

LO3

Risk in a Portfolio

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Table 13-2Betas, July 2011

LO3

Source: www.reuters.com/finance/stocks http://pages.stern.nyu.edu/~adamovar/New_Home_Page/data.html

Company Name Beta

Bombardier (BBD.bTO)…………………………………………………………. 1.40

Canadian Tire (CTC.TO)…………………………………………………………

0.63

Power Corp. (POW.TO………………………………………………………….. 0.94

Potash Corp. (POT.TO)…………………………………………………………. 1.06

RIM (RIM.TO)…………………………………………………………………….. 1.92

Royal Bank (RY.TO)………………………………………………………….......

0.67