Systematic and Unsystematic Risk - Essay Example

Finance Roll No: Teacher: 30th January 2009 Question a. Distinguish between systematic and unsystematic risk. Which is often regarded as the only relevant risk and why? Systematic risk can be defined a type of risk due to the which, the whole system and the whole market can be failed and this form of risk does not affect a part of the system but the whole system (Stulz 2003). The whole system that can be affected negatively because of the systematic risk includes assets or liabilities that are very important for a business setup. Due to this systematic risk, the values of investments can be turned down and all this can occur because of financial transformation or other incidents that can affect the market to a great extent (Stulz 2003). As far as unsystematic risk is concerned, it can be defined as a type of risk which can affect each and every investment (Stulz 2003). Unlike systematic risk, unsystematic risk can be called as a specific risk. It does not take into its captivity the whole system but affects in chunks. Unsystematic system is less threatening as compared to systematic risk. Due to this risk, the prices can be altered because of the specific security measures in comparison to the whole system or the whole market (Stulz 2003). Systematic risk cannot be escaped fully but unsystematic risk can be escaped fully if proper measures are taken (Stulz 2003). Systematic risk is also regarded as the only relevant risk because it is the one, which cannot be escaped. Systematic risk affects the organization, market and the whole system to a great extent and its affect is a must (Stulz 2003). Systematic risk is regarded as the only relevant risk because it can only be reduced by the four ways which are avoidance, retention, reduction and transfer but it cannot be ended wholesomely (Stulz 2003). b. In the context of the Capital Asset Pricing Model how would you define beta? How are betas determined and where can they be obtained? What are the limitations of betas? In the context of the Capital Asset Pricing Model (CAPM), beta coefficient can be defined as a key parameter. It is employed for the measurement of part of the asset’s statistical variance (Crosson and Needles 2008). The asset’s statistical variance cannot be lessened by means of the diversification, which is provided by the portfolio of the risky assets. The reason as to why it cannot be lessened by means of diversification is that it forms a relationship with the assets that can be retrieved back in the portfolio (Hussey 1991). Only those companies can make use of the beta coefficient that are making use of the regression analysis (Feibel 2003). When a beta can be seen in a portfolio, it means that the management is seeing some risks with the investment and is showing their willingness to take risk. The betas can be obtained when the management is ready to take the risks involved (Hussey 1991). Beta is also called as a grouping of correlation and volatility. Beta can be employed to decide the ratio of risk involved in a transaction, which contains volatility as well as correlation (Levinson 2006). For the calculation of beta, a list is required that should have the returns for the assets and returns for the index (Levinson 2006). After the identification of the returns for assets and returns for the index, a graph needs to be drawn which should have returns for the index on the x-axis and returns for the assets on y-axis (Lindert 1991). This graph is made so that the linear regression model cannot be violated (Levinson 2006). The betas are obtained on the portfolios. Beta cannot be regarded as having no limitations. When the management calculates beta for risk evaluation, they have to consider the limitations of the beta. For every country, the betas are different because they are calculated according to the stock and market of a respective country and cannot be applied on another country (Feibel 2003). Most of the times, beta is considered only in terms of its magnitude. Being a statistical variable, beta can only be considered crucial in terms of statistics (Feibel 2003). It cannot be used elsewhere but in statistical evaluations. c. What information does beta give to a financial manager? The information that a beta gives to the financial manager is about the risks that can be there whether systematic or unsystematic risks. For every risk factor, there is a separate beta that is calculated about how much risk is involved in terms of assets (Hussey 1991). The financial manager gets the information about the proximity of risk associated to an asset in terms of finance and investing. With this information, a financial manager is able to make smart decisions for investment due to which, the ratio of occurrence of risk is minimized (Hussey 1991). Systematic risk can be reduced while unsystematic risk can be eliminated wholesomely. Question 2 a. What is the time value of money? Why is it important to “discount” future cash flows? Time value of money means that one can get the interest on his/her earning today or a later time in future but the amount of the interest remains the same (Levinson 2006). The preference in terms of taking the interest today or in future wholly depends on the investor as he/she is the one to decide according to his/her needs (Crosson and Needles 2008). A fixed amount is adjusted that is to be paid to the investor. The value of the amount is not changed with the extension of the time that is there in getting the interest (Lindert 1991). The money that the investor gets is on the basis of equal value that is calculated. Present value of investment is assessed against the future value of money (Feibel 2003). The amount may differ but the value remains the same. For time value of money, many calculations are required to be done such as present value, present value of annuity, present value of perpetuity, future value and future value of annuity (Feibel 2003). All these values are required to be calculated according to the time value of money. The future cash flows need to be discounted in terms of time value of money because due to this assessment and this discount, the value of money is known which is there in the present and which, will be there in future (Crosson and Needles 2008). Future cash flows need to be discounted because in future, the interest amount that is to be received in future is different to the amount that is received in present. The amount that is received in future is more but its value is the same in present (Levinson 2006). The future, the amount that is to be received is more as compared to present value due to which, for the future cash flows, discount is necessary. b. What factors need to be taken into account when choosing an appropriate discount rate? For an appropriate discount rate, many factors are required to be considered. Firstly, what is a discount rate? A discount rate is given on the basis of the monetary policy of an organization and country (Levinson 2006). Discount rate is given on the basis of expense that a company or organization can do for obtainment of a thing (Levinson 2006). Discount rate is a kind of interest rate that is given on annual basis or any other time frame basis and it depends on the investment that is done on a project (Crosson and Needles 2008). It can be different regarding different factors such as current inflation of a country, the past level of inflation, business activity by analyzing the stock exchange, money volume and deposit ratio. These factors are considered for giving discount rates to a country (Lindert 1991). For organizations or firms, the factors for choosing an appropriate discount rate are the market position of the organization or firm, its assets, its liabilities, expense, earning, market trend, approach of buyers and the size of the organization or firm. The market position of a firm or organization informs about the capacity of the organization or firm to invest (Lindert 1991). The market position also informs whether the firm or organization is reliable for an appropriate discount rate or not. The assets and liabilities of an organization inform about the financial status of an organization or firm due to which, a discount rate can be set according to the assets and liabilities that a company has (Lindert 1991). The size of the organization or firm is also a factor that can be considered while giving a discount rate. On the basis of expense, discount rate is specified. The giver of discount rate has to consider the expenses done by the investor. Discount rate can differ according to the expenses (Lindert 1991). When the expense is more, discount rate will also be more and in case of less expense, the discount rate will also be less. Discount rate is also given on the basis of the earning that an organization is able to have for doing an investment (Levinson 2006). When the earning is greater, the discount rate will be greater and for less earning, the discount rate will also be less. Earning of an organization or firm can be different in different times due to which, the discount rate may change from time to time and according to the investor. Market trend is also a factor that is considered crucial in providing a discount rate or choosing a discount rate. When there is a competitive environment, the discount rates offered are also competitive and are much beneficial for the investor (Lindert 1991). Due to market trend, the discount rate is chosen according to the market rates. The discount rate is also chosen on the basis of investor’s approach. Investor is involved in the choosing of discount rate along with the organization or firm due to which, the discount rates can be set between the investor and firm or organization (Levinson 2006). Therefore, it is quite clear that discount rates differ and are chosen on the basis of certain factor, which can impact the discount rate to a great extent. c. What do you understand by the terms (i) “net present value” (NPV) and (ii) “internal rate of return” (IRR)? Net present value (NPV) assumes that the organization requires a rate of return on capital (Feibel 2003). The steps in the calculation are firstly to calculate the annual net cash flows expected from the investment for the period considered to be expected life of the investment; then to apply the chosen discount factor to these cash flows and finally, to compare the total of those discounted cash flows with the initial outlay (Crosson and Needles 2008). The comparison should demonstrate that the cash flow is the larger if the investment is to be approved. For calculating the cost / benefit of a projected investment, internal rate of return (IRR) is employed as a method. It can be defined as profit multiplied by 100 and divided by the capital employed (Feibel 2003). It can also be defined as average annual net profit before interest and tax divided by initial capital employed on the project multiplied by 100 or average annual net profit before interest and tax divided by average annual capital employed on the project multiplied by 100 (Feibel 2003). d. Compare and contrast the NPV and IRR. The methods of calculation, net present value (NPV) and internal rate of return (IRR) are quite contrasting as compared to each other. Net present value is concerned with the value that is added to the firm on the basis of an investment or a project while internal rate of return is concerned to the efficiency or quality that is attached with an investment (Crosson and Needles 2008). NPV is an indicator of value of investment while IRR is an indicator of efficiency of an investment (Hussey 1991). With internal rate of return, the question that comes to mind is, “What rate of return would be required to ensure the total NPV equals the total initial cost?” in other words, the IRR requires only that the total NPV over the agreed life of investment of project is equal to the total initial cost of the project or investment (Feibel 2003). The most important requirement of any method of cost benefit analysis is that it is consistent with the organization (Hussey 1991). Both of the methods, NPV and IRR are methods for cost benefit analysis but in calculation IRR makes use of NPV. Both of these are methods of capital budgeting (Feibel 2003). The NPV can be depended upon in terms of rejection or acceptance of a project or investment. If the net present value is greater than zero, then the project or investment can be accepted, if the case is otherwise that means that net present value is less than zero, then the project or investment is rejected (Crosson and Needles 2008). When the net present value is greater than zero, the organization gains on the basis of investment while when net present value is less than zero, the organization loses on the basis of investment. IRR also depends on net present value. IRR is adopted for long term as well as short term projects but NPV is adopted for long term projects (Feibel 2003). References Crosson, S.V. and Needles, B.E 2008, Managerial Accounting, (8th Ed), Houghton Mifflin Company, Boston. Feibel, Bruce J 2003, Investment Performance Measurement, Wiley, New York. Hussey (Ed.) 1991, Understanding Business and Finance, DP Publications, London. Levinson, Mark 2006, Guide to Financial Markets, The Economist, London. Lindert, Peter H 1991, International Economics, (9th Ed.), IRWIN, New York. Stulz, Rene M 2003, Risk Management & Derivatives, (1st Ed.), Thomson South-Western, Mason, Ohio. Read More