Risk and return relationship

1. Risk and return relationship Lecture 2

2. Lecture outline • What is risk? • How risk is measured? • Types of risk • Risk Characteristics of Technology Start-ups • Risk and return trade-off • Risk and project life cycle • Risk management framework • Conclusion: Questions to ask.

3. What is risk? • Risk presents when the possible outcomes may deviate from the expected outcomes. • More than one possible outcomes • Actual outcome may be different from expected. • Can have both upside and downside risks • Heavy focus on the downside risks • But remember there is a potential upside otherwise why should anyone take risks?

4. Let’s go an example • You are interested in a venture in the chemical industry. You have researched for the price to earnings ratios of the listed firms in the industry. • These P/E ratios provide a ground to estimate the possible P/E value for your prospect firm.

5. P/E ratios of 80 Bio-chemical firms

6. These price to earnings ratios can be organised in the form of an array…

7. A probability distribution can be derived for the data set… Data are grouped into classes and the number of observations.

8. A frequency distribution can be presented using histograms and frequency polygons… Frequency Polygon Histogram 20 20 15 15 10 10 5 5 P/E Ratio P/E Ratio 0 10 20 30 40 50 0 10 20 30 40 50

9. Important parameters • A population can be measured by its: • Central tendency (average performance) • Mean • Mode • Median • Dispersion (range of possible outcomes) • Range • Standard Deviation • Variance

10. Mean value (Expected value) • The arithmetic mean gives the expected valueof a population, denoted as E(X): • Example: • The price/earnings ratios (X) of six company stocks are: • 10, 11, 12, 14, 14, 50 • The expected value (mx)of price/earnings ratios of this group of stocks is given by:

11. Notes on using mean value (expected) • Arithmetic mean is defined by all values in a data set. • “Outliers” may result in a distorted measure of central tendency • Need to consider other values such as modes and median. • Modes and median are not affected by the outliers. • In the previous example: 10, 11, 12, 14, 14, 50 • Mode is 14. • Median is 13 • So what can we say about the expected P/E?

12. Risk measured by dispersion • Range – simplest measure of dispersion • The range is the difference between the highest and lowest values in the population. • In the previous example: 10, 11, 12, 14, 14, 50 • The range of the price/earnings ratios of the 6 stocks is Rx = 50 – 10 = 40

13. Risk measured by dispersion • Variance: • a common measure of risk • Variance of a population is: The variance of the price/earnings ratio of the five stocks is calculated as follows:

14. Risk measured by dispersion • Standard deviation • The standard deviation of a population is the square root of its variance… • Very sensitive to extreme values

15. For a continuous normal random variable, the probability distribution has the following characteristics… m 68% 95% 99.7% Standard Deviation From The Mean -4s -3s -2s -s 2s 3s 4s s

16. Interpreting the results • Expected value = 18.5 • Standard deviation = 14.2 • 68% chance: P/E falls into the range: 4.3 – 32.7 • 95% chance: P/E falls into the range: 0 – 46.9 • 99% chance: P/E falls into the range: 0 – 61.1 • Note the impact of the outliers in this calculation.

17. Using probability distribution…. EXAMPLE If a company is expected to earn $1.50 per share with a standard deviation of $0.20, the confidence limits on the actual earnings are:

18. Class quiz • If a company share price is expected to be $10 and its daily standard deviation is $2. What is the chance of having the price to go up to $20 in one day?

19. Measuring Risk Low risk project Standard deviation  High risk project -ve 0 +ve Expected returns

20. Firm X Firm Y Rate of Return (%) -70 0 15 100 Expected Rate of Return Please comment:

21. Risk: Portfolio vs Stand-Alone There are two aspects of risk to be considered in examining a technology venture in relation to the portfolio and to individual projects

22. Risk: Portfolio vs Stand-Alone • Stand-alone: not diversifiable • Portfolio risk: diversifiable Portfolio Risk Implications: • Risk analysis may imply that the multi project start-up, be able to spread its risk over a number of project might be more willing to take on higher financing costs, whereas the single project start-up is more conservative in its financing strategy • Risk tolerance of the start-up will depend on the risk aversion of the owners.

23. Types of project risk • Three typical types of project risks: • stand-alone risk, • corporate risk and • market risk

24. Project stand-alone risk • What is the project’s stand-alone risk? • Project risk relates to the uncertainty about future operating income (EBIT), • How well can we predict operating income?

25. Corporate risk • How the project fits in with the current corporate strategy and structure • Financial aspects • Human resource aspects (esp. management) • Marketing and strategy • If the project fails, will it affect the other business of the firm? • If the firm fails in any other business, how this project is going to be influenced?

26. Market risk • How the market may impact on the project • Commodity markets • Financial markets • Interest rate market • Foreign exchange markets • An indicator of market risk is BETA. • Beta: systematic (market) risk of the business • Note: Firm beta vs. project beta

27. Company Betas CNET Networks 2.27 EDS 0.61 Nokia 2.05 Oracle 1.76 SAP 1.56 CISCO 2.00 Microsoft 1.80 AOL-Time Warner 2.57 Source: Yahoo Finance, 24 April 2002 How to estimate BETA? How to interpret BETA value?

28. Australian E-Commerce Returns and Volatility

29. How to estimate Beta? • Regression • Stock returns against market returns  firm’s beta • If the project is funded with the same D/E structure as the current structure  use the firm beta as the project beta • If the project is funded with equity only  find the unlevered beta from the firm beta.

30. How to estimate Beta? • What if it is not a public company? • Find beta of a comparable firm • Adjust for leverage level • What if there is no comparable company? • Entrepreneurial venture • Use earnings beta (find by regression)

31. Why take risks?

32. Risk – Return Trade-Off Therefore the decision to proceed with a new project development, i.e. commitment of resources, should be based on an assessment of expected returns from the project against its risk exposures.

33. Risk – Return Trade-Off In this context, management should ask the following risk related questions: • Is the new project crucial to the firm’s performance and how does it fit with the firm business strategy? • Does the startup possess or have access to the necessary expertise/experience to successfully complete the project? • What is the level of resources to be committed? • What is the expected risk-return trade off in the project?

34. Risk and return trade-off • The greater the risk the greater the potential to create value – but also the greater potential to destroy value.

35. Risk Characteristics of Technology Start-ups • extremely risky • Depends on the level of experience and technical skills • Track record • Risk to future firms’ revenue and profitability • More difficult to estimate cash flow • More difficult to estimate discount rate • Risks change over project life cycle

36. Risk and Technology Start-ups • A highly risky project may achieve a certain degree of market success, but with considerable costs,such as: • longer PLC • higher costs • lower profit margins • loss of market share

37. Risk and Technology Start-ups • Factors influencing risk level of technology start-ups: • The potential market size; • Thetype of financing available and cost; • The technical and scientific basis and support for the project; • The degree of previous experience with the technology, both within the firm and in other companies; • Proximity of the performance and physical specifications to the limits of the technology;

38. Risk and Technology Start-ups Critical management decisions: • what risk to take • what investment to make • when to proceed to the next step in the cycle • when to terminate a program

39. Risk and Technology Start-ups The relationship between the degree of risk exposure a firm may be willing to take in relation to level of technological innovation or advancement was analysed by Hayes (1985).

40. Risk and Technology Start-ups Hayes looked at how big a technical quantum leap a start-up should take in the technology, issues are: • The size of the leap will determine the direction, cost and risk of the technology start-up • If the goals are too ambitious resulting in a wide gap between the old and new technology and process, this may result in a weak technical base or inadequate skills to support such a leap • On the other hand, by aiming for marginal technological change may reduce the risk exposure but lose the market to more aggressive competitors.

41. Risk and Technology Start-ups Hayes likens the different technology adoption strategies to the tortoise and the hare: • the first method is more logical, predictable and less risky • the second approach is a technological revolution strategy, which is very risky

42. Risk and Technology Start-ups Hayes comments that: • US companies do, however, tend to adopt approaches toward the strategic leap end • US two most powerful competitors, Germany and Japan, tend to seek incremental improvements within an existing structure and technology

43. Risk and Technology Start-ups The following table presents the different levels of risk to technology adoption strategy: Evolutionary 1. Evolutionary – Low risk ·        Small dimensional changes ·        Addition of few standard components

44. Risk and Technology Start-ups Incremental 2. Incremental – Moderate risk ·Introduction of one or two significant new inventions, important process changes, design features ·    Addition of major new sub-system ·    Significant increase in density of parts, size reduction 3. Incremental – High risk ·  Introduction of four or five significant new inventions, major process changes, design features ·   Addition of two or three major new sub-systems ·   Major change in materials of several key components

45. Risk and Technology Start-ups Revolutionary 4. Revolutionary – Very high risk ·        Major change in principles of operation ·        Major change in technology (The Internet, fiber optics, genetic engineering, 3-G broadband technology etc.)

46. Risk and the Project Life Cycle • The uncertainties associated with a project decline over its life cycle • the technical uncertainties pertaining to the viability of the project and the market uncertainties associated with consumer acceptance of the project are relatively higher in the early stages • they decline in later stages of the project

47. Risk and the Project Life Cycle The early planning phase is a critical point in the project life cycle in terms of: • projectfeasibility evaluation; • resource allocation, and • financing strategy and this sets the stage forthe ensuing economicperformance of theproject

48. Risk and the Project Life Cycle • the planning stage that requires the leastamount of resources and therefore the lowest risk in the project life cycle • The development stage has the highest risk because of the resources committed to the project against the high level of uncertainties associated with the project • These uncertainties (risks) will start to diminish as the project evolves and more information is available for assessing the technical feasibility of the project

49. Risk Management Framework • 4 strategies to deal with risks • Accept • Transfer • Mitigate • Avoid • The application depends on the risk aversion and experience level of the business.

50. Risk Management Framework • Identify the project’s critical/ source of risk exposure; • Quantify the exposure • Assess the impact of the risk exposure • Strategically (market, HR…) • Financially • Prepare a strategy/plan for resolving each risk; • Monitor and update the risk management, plan, and results periodically; • Highlight risk-item status in reviews; and • Initiate appropriate corrective actions.