Risk and Return Analysis of Les Risky - Case Study Example

Finance Manager’s Analysis Students’ Name Subject Professor University/Institution Location Date Contents Executive Summary 2 Introduction 3 Case 1: Les Risky’s Investment Fund 3 Les Risky’s Risk Appetite 3 Return and Risk Analysis of Chosen Companies 4 CAPM 9 CASE 2: The Privatization of Telestra Corporation Limited 10 Major Decision-Making Factors in Planning the Sale of Telestra 10 Conclusion 13 References 13 Executive Summary The first part of the report covers risk and return analysis using a case study of Les Risky. Various techniques are employed in the analysis such as CAPM, Sharpe ratio and Treynor Ratio in the analysis of Les Risky’s risk and return expectations. In the second part, a case of privatization is analyzed. Introduction Financial managers have to invest in an asset or portfolio depending on risk appetite and expected returns of their clients. Financial decisions pose certain characteristics of risk and return that ultimately influence the share price. Return is the expected total benefit or loss from an investment over a given period of time and is manifested in dividends, capital gain or interest. Risk is seen as a probability of a financial loss that results from the unpredictability of returns related to a particular asset. Case 1: Les Risky’s Investment Fund Les Risky’s Risk Appetite He is a risk taker because he has decided to use his savings in starting a self-managed investment fund. He has to consider market risk, business risk, interest rate risk, and liquidity risk because they affect share price. The traditional risk and return concepts suggest that a positive relationship should exist between the risk associated with an investment security and the relative return that it provides to the holders. When the risk increases, there should be a corresponding increase in returns. Risk takers get a higher interest rate which compensates them for the higher chance of losing their assets (Christoffersen 2012). Risk can be associated with a single asset or with a portfolio. Unsystematic risk is firm-specific, diversifiable and can be measured by standard deviation. On the other hand, systematic risk is not diversifiable and is measured using beta. In addition, there exists moral risk which arises when financial managers are unethical (Brigham & Ehrhardt 2013). Les employed standard deviation to measure asset risk. Table 1 shows part of Les’s preliminary analysis of desirable company investments using historical share price information on chosen companies and displays total return and standard-deviation measures for the last financial year (from 1/7/00 to 30/6/01), and beta coefficients for prediction purposes using individual share and market-return data for the previous financial year (from 1/7/99 to 30/6/00): Table 1 Company Name Total share return (%) Standard deviation of daily returns (%) Beta coefficient National Australia Bank 10.97 1.62 0.906 Coca- Cola Amatil -62.78 2.73 0.718 James Hardie Industries 9.28 2.07 0.626 Lend Lease Corporation 2.69 1.75 0.683 News Corporation 57.90 3.42 2.625 Sons of Gwalia 27.77 2.45 0.349 Westfield Trust 5.81 1.04 0.381 Woodside Petroleum 23.96 2.08 0.778 All Ordinaries Index 12.28 0.92 1.000 Return and Risk Analysis of Chosen Companies National Australia Bank has a positive relationship between total return and risk because it has a positive return of 10.97% and a standard deviation of 1.67%. Coca Cola Amatil has a negative relationship between total returns and risk because it has a negative return of -62.78% and a standard deviation of 2.73%. Therefore, Coca Cola Amatil violates the positive relationship between risk and relative return in an investment to shareholders and should be rejected as an investment choice by Les. James Hardie Industries has a positive relationship between total return and risk because it has a positive total return of 9.28% and a standard deviation of 2.07%. Lend Lease Corporation has a positive relationship between return and risk because it has a positive return of 2.69% and a standard deviation of 1.75%. News Corporation has a positive relation between return and risk because it has a positive return of 57.90% and a standard deviation of 3.42%. Sons of Walia have a positive relationship between return and risk because it has a positive return of 27.77% and a standard deviation of 2.45%. Westfield Trust has a positive relationship between return and risk because it has a positive return of 5.81% and a standard deviation of 1.05%. Woodside Petroleum has a positive relationship between return and risk because it has a positive return of 23.96% and a standard deviation of 2.08%. In light of the analysis, all the chosen companies apart from Coca Cola Amatil are eligible to be included in a portfolio. The concept of portfolio theory holds because risk has been effectively minimized in All Ordinaries Index. The All Ordinaries Index has the smallest standard deviation of 0.92% at a positive return of 12.28% implying that it has the least risk. All other investments by individual companies have a standard deviation that is more than that of the index. Kemp (2011) argues that a portfolio has to be efficient and well diversified. For instance, the investments of companies with low positive correlations can be combined to minimize risk. The lower the positive correlation among investments the lesser the risk there will be in the resulting portfolio. The combination of uncorrelated assets or assets that have a correlation coefficient that tends to zero is capable of reducing risk more than the combination of investments that have a positive correlation.  However, the combination of assets that have a perfect negative correlation and a perfect positive correlation is the best option when minimizing risks through the diversification of a portfolio. The relative correlation coefficients that Les calculated to determine the relationship between the daily share-price movements of these companies are shown in table 2. NAB CCL HAH LLC NCP SGW WFT WPL NAB 1.000 0.150 O.211 O.176 0.117 0.163 0.309 0.187 CCL 1.000 0.253 0.091 -0.001 0.139 0.323 0.218 HAH 1.000 0.075 0.111 0.101 0.200 0.212 LLC 1.000 0.118 0.184 0.198 0.109 NCP 1.000 0.002 0.116 0.120 SGW 1.000 0.124 0.041 WFT 1.000 0.176 WPL 1.000 Table 2 From table 2 of correlation coefficients as calculated by Les, News Corporation Company shares, Sons of Gwalia Company shares and Lend Lease Corporation shares are the three companies’ shares recommended for Les initial portfolio because they have the lowest positive correlation coefficient values and will therefore minimize risk in his intended initial portfolio. Les intends to hold the companies’ shares in equal proportions. Portfolio return is calculated using the formula; Portfolio return (PR) = W1R1 + W2R2 + W3R3 Where; W1, R1, W2, R2, W3 and R3 represent weight of News Corporation Company shares, return of News Corporation Company shares, weight for Sons of Gwalia company shares, return for Sons of Gwalia Company shares, weight for Lend Lease Corporation shares and return of Lend Lease Corporation shares. The formula for portfolio standard deviation is given as; ∂p = √ [∂12 W12 + W22∂22 + W32∂32+ 2W1 W2 COV AB + 2W1 W3 COV AC + 2 W2 W3 COV BC] Where; A, B and C represent News Corporation, Sons of Gwalia and Lend Lease Corporation, respectively. ∂p, ∂1, ∂2 and ∂3 represent portfolio standard deviation, News Corporation standard deviation, Sons of Gwalia standard deviation and Lend Lease Corporation standard deviation. Cov and cor represent covariance and correlation, respectively. Return (%) Weight Weight2 (W2) Portfolio return Variance (∂2) Covariance Cov =cor*∂1∂2 News Corporation Company 57.90 1/3 1/9 19.3 3.422 = 11.697 3.42*0.002*2.45 = 0.017 Sons of Gwalia 27.77 1/3 1/9 9.257 2.452 = 6.003 0.184*1.75*2.45 = 0.789 Lend Lease Corporation 2.69 1/3 1/9 0.897 1.752 = 3.063 0.118*1.75*3.42 = 0.661 Total 29.454 Portfolio return = (57.9) (1/3) + (1/3) (2.69) + (27.77) (1/3) = 29.454 % Portfolio standard deviation (∂p) = √ [11.697*(1/9) + 6.003*(1/9) + 3.063*(1/9) + 2*(1/3) (1/3) (0.017) + 2*(1/3) (1/3) (0.789) + 2*(1/3) (1/3) (0.661)] = 1.623 The portfolio of Les outperforms the index because it yields higher returns. Risk – free rate = 5.20% Sharpe measure = (portfolio return – risk- free rate)/ portfolio standard deviation = (29.454 – 5.20)/ 1.623 = 14.944 14.944 ˃ 12.28 therefore outperforms All Ordinaries Index. The risk-free rate is deducted from the portfolio return because a risk-free asset as frequently exemplified by the Treasury-bill, has zero risk premium and a certain return (Connor, Goldberg & Korajczyk 2010). Therefore, the Sharpe ratio measures the performance of the portfolio in relation to the risk taken implying that a higher Sharpe ratio represents a better performance and greater profits for taking additional risk. Treynor Ratio (Portfolio Return – Risk-Free Rate) Portfolio Beta Portfolio Beta = (W1) (Beta of News Corporation) + (W2) (Beta of Sons of Gwalia) + (W3)( Beta of Lend Lease Corporation) = (1/3) (2.625) + (1/3) (0.349) + (1/3) (0.683) = 1.219 Treynor Ratio = (29.454 - 5.20) 1.219 = 28.235 28.235 ˃ 12.28 therefore outperforms All Ordinaries Index. Treynor ratio is higher with either higher portfolio returns or lower portfolio betas. Subsequently, it measures the return per unit risk. CAPM Expected return (ER) = Risk-free rate + (Market Return – Risk-free rate) Asset Beta ER for News Corporation = 5.20 + (12.28 – 5.20) (2.625) = 18.585 ER for Sons of Gwalia = 5.20 + (12.28 – 5.20) (0.349) = 7.671 ER for Lend Lease Corporation = 5.20 + (12.28 – 5.20) (0.683) = 10.036 Portfolio return = (W1) (ER for Sons of Gwalia) + (W2) (ER for Sons of Gwalia) + (W3) (ER for Lend Lease Corporation) CAPM Portfolio Return = (1/3) (18.585) + (1/3) (7.671) + (1/3) (10.036) = 12.097 Actual return of 29.454 is greater than CAPM return of 12.097 which shows that CAPM may not provide accurate results because of its assumptions such as the assumption of no taxes and zero transaction costs. The results disagree with CAPM because higher actual returns are attained by the portfolio of Les. CASE 2: The Privatization of Telestra Corporation Limited Major Decision-Making Factors in Planning the Sale of Telestra There would have been a surfacing of a tight fiscal surroundings and the call for government control of expenditure and debt (Chiou, Lee & Lee 2010).For instance, proceeds from the sale of government business enterprises (GBEs) in the 1990s, such as the Commonwealth Bank, Qantas Airways and the Commonwealth Serum Laboratories were utilized in reducing Commonwealth Government debt and in lowering the interest repayment burden on the Commonwealth Government budget. There would have been disappointment with the overall performance of government-owned enterprises and a wish to improve efficiency. One of the arguments put forward by the Commonwealth Government in support of privatizing Telstra was that it would open up the telecommunications industry in Australia to competition with the aim of lowering the cost of telecommunications products and improving the level of service provided to customers. Specifically, those people and businesses in rural Australia, whose access to communications services was greatly restricted relative to those provided in metropolitan areas. There would have been technological changes in various sectors such as telecommunications that made the monopolistic provision of particular commodities and services obsolete (Duso & Seldeslachts 2010). Until recently, and at the time of the Telstra 1 float in October 1997, Telstra maintained a monopoly in the provision of local telephone calls in Australia and also had a dominant share of the long-distance and international telephone communications markets. The company had a competitive advantage in the developing mobile-phone and internet services markets and owned and maintained the Australia-wide network and cabling infrastructure and the directory businesses of both the WhitePages and the YellowPages. The financial markets started to be a world-wide avenue for acquiring capital and in the process created new opportunities for firms to obtain finance and create more wealth for their shareholders. Government-owned firms needed to acquire equity from capital markets (Saunders & Cornett 2012). However, government-owned firms had to relinquish control that was restricting both domestic and international investors from accessing them. The Commonwealth Government of Australia announced the partial privatization of its telecommunications assets, in the form of Telstra Corporation Ltd, in October 1997. The Telstra 1 public float involved an invitation to Australian residents, business investors, large institutional investors and foreign investors to subscribe for a minimum of 400 Telstra shares. Reasons for employing the installment payment and book-build instruments Installment payment was adopted because it creates increased participation and attention in an auction. As a result, the present value of a bid tends to be higher and decreases the likelihood of auctions being terminated. The book-build instruments facilitate a selection procedure that is not only transparent but also efficient when appropriately designed and conducted. A potential drawback is when government fails to properly design an installment plan which might harm the aptitude of winning bidders to acquire funds for the rest of their capital requirements. Installment and book-build instruments offer an advantage in managing risks as they can be used to manage a variety of risks such as, default risk to government, credit risk to capital markets, technology and commercial risk that can be addressed by a well-designed auction. General Public View of the Success Level Associated with the Telstra 1 and Telstra 2 share Offers Telestra 1share offers were a success because investors were already cashing in on ‘stag’ premiums and institutional investors increasing their holdings in line with Telstra’s proposed weighting in the All Ordinaries Index on the first day. Telestra 2 share offer was a flop because it resulted to a capital loss to shareholders due to the share price of Telstra falling significantly during 2000. At the time of the required second installment for Telstra 2 issue shares, the share price of the company had fallen to approximately $5.20, representing a paper loss of $2.60 per share upon payment of the final installment. Commonwealth Government Perspective of the Success Level Associated with the Telstra 1 and Telstra 2 Share Offers Telestra 1 share offer was a success because the shares continued to increase in value in response to increased profitability results for the company and payment of the second installment by subscribers and achieved a high price of approximately $9.15 within two years of the initial listing date. Telestra 2 share offer was a success because there was increased competition in the telecommunications from new entrants into the telecommunications industry in Australia, such as Cable & Wireless Optus, One Tel, AAPT and Hutchison Telecommunications. Conclusion Finance managers and individual investors have to take into consideration their risk appetite and return expectations when making an investment. Investors can maximize their wealth by investing in capital markets. References Brigham, E, & Ehrhardt, M :2013 Financial management: theory & practice Cengage Learning. Chandra, P :2011 Financial management Tata McGraw-Hill Education. Chiou, W J P, Lee, A C, & Lee, C F :2010) Stock return, risk, and legal environment around the world International Review of Economics & Finance, vol, 19 no.1. pg 95-105. Christoffersen, P F :2012 Elements of financial risk management Academic Press. Connor, G, Goldberg, L R, & Korajczyk, R A :2010 Portfolio risk analysis Princeton: Princeton University Press. Duso, T, & Seldeslachts, J :2010 The political economy of mobile telecommunications liberalization: Evidence from the OECD countries Journal of Comparative Economics, vol, 38 no.2. pg 199-216. Kemp, M H :2011 Extreme events: Robust portfolio construction in the presence of fat tails Chichester, West Sussex: Wiley. Saunders, A, & Cornett, M M :2012 Financial markets and institutions McGraw-Hill/Irwin. Read More