SU 6: Risk Return Principals

During the year just ended, Deet Corp. experienced the following power outages: Outages Number of Per Month Months 0 3 1 2 2 4 3 3 12 Each power outage results in out-of-pocket costs of $400. For $500 per month, Deet can lease an auxiliary generator to provide power during outages. If Deet leases an auxiliary generator for the current year, the estimated savings (or additional expenditures) would be

$1,600

A beverage stand can sell either soft drinks or coffee on any given day. If the stand sells soft drinks and the weather is hot, it will make $2,500; if the weather is cold, the profit will be $1,000. If the stand sells coffee and the weather is hot, it will make $1,900; if the weather is cold, the profit will be $2,000. The probability of cold weather on a given day at this time is 60%. The expected payoff for selling coffee is

$1,960

Beginning January 2, Year 1, a company deposited $50,000 in a savings account for 2 years. The account earns 10% interest, compounded annually. What amount of interest did the company earn during the 2-year period?

$10,500

A company has an online order processing system. The company is in the process of determining the dollar amount of loss from user error. The company estimates the probability of occurrence of user error to be 90%, with evenly distributed losses ranging from $1,000 to $30,000. What is the expected annual loss from user error?

$13,950

Fact Pattern: A company is considering three alternative machines to produce a new product. The cost structures (unit variable costs plus avoidable fixed costs) for the three machines are shown as follows. The selling price is unaffected by the machine used. Single purpose machine $.60x + $20,000 Semiautomatic machine $.40x + $50,000 Automatic machine $.20x + $120,000 The demand for units of the new product is described by the following probability distribution. Demand Probability 200,000 0.4 300,000 0.3 400,000 0.2 500,000 0.1 Ignoring the time value of money, the expected cost of using the semiautomatic machine is

$170,000

Listed below are four numbers. Which of these numbers represents the coefficient of correlation of a stock portfolio with the least unsystematic risk?

-1.0

Under frost-free conditions, Cal Cultivators expects its strawberry crop to have a $60,000 market value. An unprotected crop subject to frost has an expected market value of $40,000. If Cal protects the strawberries against frost, then the market value of the crop is still expected to be $60,000 under frost-free conditions and $90,000 if there is a frost. What must be the probability of a frost for Cal to be indifferent to spending $10,000 for frost protection?

.200

Fact Pattern: The probabilities shown in the table below represent the estimate of sales for a new product. Sales (Units) Probability 0-200 15% 201-400 45% 401-600 25% 601-800 15% Using the midpoint of each range as the best estimate for that range, what is the best estimate of the expected sales of the new product?

380

Which of the following is not a political risk of investing in a foreign country?

A foreign customer might default on its debt.

To estimate the NRV of the inventory, management will probably consider the following sources except

Costs incurred to date.

Which of the following factors would not be relevant when determining the risk premium on a specific security?

Earnings per share.

An investment security with high risk will have a(n)

High standard deviation of returns.

Many assumptions and factors may be considered to determine the fair value except

Historical cost.

Management's financial estimates are based on all of the following except

Known outcomes.

A company experiences both variable usage rates and variable lead times for its inventory items. The probability distributions for both usage and lead times are known. A technique the company could use for determining the optimal safety stock levels for an inventory item is

Monte Carlo simulation.

From the viewpoint of the investor, which of the following securities provides the least risk?

Mortgage bond.

If a CPA's client expected a high inflation rate in the future, the CPA would suggest to the client which of the following types of investments?

Precious metals.

Management utilizes all of the following procedures to develop accounting estimates except

Quantifying confidence in the estimate.

A widely used approach that managers use to recognize uncertainty about individual items and to obtain an immediate financial estimate of the consequences of possible prediction errors is

Sensitivity analysis.

In decision theory, those uncontrollable future events that can affect the outcome of a decision are

States of nature.

The risk of a single stock is

Unsystematic risk.

Global companies that deal with the political and financial risks of conducting business in a particular foreign location face which of the following types of risk?

country risk

Pongo Company's managers are attempting to value a piece of land they own. One potential occurrence is that the old road bordering the land gets paved. Another possibility is that the road does not get paved. A third outcome is that the road might be destroyed and completely replaced by a new road. Based on the following future states of nature, their probabilities, and subsequent values of the land, what is the expected value of the land? Future States of Nature (SN) Probability SN 1: Current road gets paved .5 SN 2: Road does not get paved .4 SN 3: Current road destroyed and replaced with new road .1 Estimates of land value under each possible future state of nature: Value if SN 1: $200,000 Value if SN 2: $100,000 Value if SN 3: $550,000

$195,000

Johnson Software has developed a new software package. Johnson's sales manager has prepared the following probability distribution describing the relative likelihood of monthly sales levels and relative income (loss) for the company's new software package. Monthly Sales In Units Probability Income(Loss) 10,000 .2 $(4,000) 20,000 .3 10,000 30,000 .3 30,000 40,000 .2 60,000 If Johnson decides to market its new software package, the expected value of additional monthly income will be

$23,200

During the past few years, Wilder Company has experienced the following average number of power outages: Number per Month Number of Months 0 3 1 2 2 4 3 3 12 Each power outage results in out-of-pocket costs of $800. For $1,000 per month, Wilder can lease a generator to provide power during outages. If Wilder leases a generator in the coming year, the estimated savings (or additional expense) for the year will be

$3,200

Scarf Corporation's controller has decided to use a decision model to cope with uncertainty. With a particular proposal, currently under consideration, Scarf has two possible actions, invest or not invest in a joint venture with an international firm. The controller has determined the following. Action: Invest in the Joint Venture Events and Probabilities: Probability of success = 60% Cost of investment = $9.5 million Cash flow if investment is successful = $15.0 million Cash flow if investment is unsuccessful = $2.0 million Additional costs to be paid = $0 Costs incurred up to this point = $650,000 Action: Do Not Invest in the Joint Venture Events: Costs incurred up to this point = $650,000 Additional costs to be paid = $100,000 Which one of the following alternatives correctly reflects the respective expected values of investing versus not investing?

$300,000 and $(100,000).

A vendor offered Wyatt Co. $25,000 in compensation for losses resulting from faulty raw materials. Alternatively, a lawyer offered to represent Wyatt in a lawsuit against the vendor for a $12,000 retainer and 50% of any award over $35,000. Possible court awards with their associated probabilities are as follows: Award Probability $75,000 0.6 $0 0.4 Compared with accepting the vendor's offer, the expected value for Wyatt to litigate the matter to a verdict provides a

$4,000 loss.

At the beginning of Year 1, $100,000 is invested at 5% interest, compounded annually. What amount of interest is earned in Year 2?

$5,250.00

Dough Distributors has decided to increase its daily muffin purchases by 100 boxes. A box of muffins costs $2 and sells for $3 through regular stores. Any boxes not sold through regular stores are sold through Dough's thrift store for $1. Dough assigns the following probabilities to selling additional boxes: Additional Sales Probability 60 .6 100 .4 What is the expected value of Dough's decision to buy 100 additional boxes of muffins?

$52

The sales manager of Serito Doll Company has suggested that an expanded advertising campaign costing $40,000 would increase the sales and profits of the company. He has developed the following probability distribution for the effect of the advertising campaign on company sales: Sales increase (units) Probability 15,000 .10 30,000 .35 45,000 .10 60,000 .25 75,000 .20 The company sells the dolls at $5.20 each. The cost of each doll is $3.20. Serito's expected incremental profit, if the advertising campaign is adopted, is

$53,000

Philip Enterprises, distributor of video discs, is developing its budgeted cost of goods sold for next year. Philip has developed the following range of sales estimates and associated probabilities for the year: Sales Estimate Probability $ 60,000 25% 85,000 40 100,000 35 Philip's cost of goods sold averages 80% of sales. What is the expected value of Philip's budgeted cost of goods sold?

$67,200

A company is conducting a risk analysis on a project. One task has a risk probability estimated to be 0.15. The task has a budget of $35,000. If the risk occurs, it will cost $6,000 to correct the problem caused by the risk event. What is the expected monetary value of the risk event?

$900

If two projects are completely and positively linearly dependent (or positively related), the measure of correlation between them is

+1

In theory, which of the following coefficients of correlation would eliminate unsystematic risk in an investment portfolio?

-1.0

Fact Pattern: The state of the economy has a strong effect on the expected returns for Techspace, Inc., as shown below: State of the Economy Probability Techspace Returns Recession .35 -10% Stable .40 10% Expansion .25 30% Given that the standard deviation (σ) of Techspace returns is 15.36% and the expected rate of return is 8%, the coefficient of variation is

1.92

The following information pertains to a company's potential investment in security X: Maturity risk premium 1% Liquidity risk premium 3% Default risk premium 2% Risk-free rate 4% What is the company's required rate of return for the investment in this security?

10%

Stock X has the following probability distribution of expected future returns: Expected Probability Return .1 -20% .2 5% .4 15% .2 20% .1 30% The expected rate of return on Stock X is

12%

The following information pertains to three shipping terminals operated by Krag Corp.: Percentage of Percentage Terminal Cargo Handled of Error Land 50 2 Air 40 4 Sea 10 14 Krag's internal auditor randomly selects one set of shipping documents, ascertaining that the set selected contains an error. The probability that the error occurred in the land terminal is

25%

The following information is available on market interest rates: The risk-free rate of interest 2% Inflation premium 1% Default risk premium 3% Liquidity premium 2% Maturity risk premium 1% What is the market rate of interest on a 1-year U.S. Treasury bill?

3%

Konstans Corp. is considering purchasing an investment security with the following information: Likelihood Return on Investment 50% 2% 40% 4% 10% 14% The expected return on this investment is

4%

Fact Pattern: The College Honor Society sells hot pretzels at the home football games. The pretzels are sold for $1.00 each, and the cost per pretzel is $.30. Any unsold pretzels are discarded because they will be stale before the next home game. The frequency distribution of the demand for pretzels per game is presented as follows: Unit Sales Volume Probability 2,000 pretzels .10 3,000 pretzels .15 4,000 pretzels .20 5,000 pretzels .35 6,000 pretzels .20 The estimated demand for pretzels at the next home football game using an expected value approach is

4,400 pretzels.

Dr. G invested $10,000 in a lifetime annuity for his granddaughter Emily. The annuity is expected to yield $400 annually forever. What is the anticipated annual rate of return for the annuity?

4.0%

Fact Pattern: Stan Berry is considering selling peanuts at the Keefer High School football games. The peanuts would cost $.50 per bag and could be sold for $1.50 per bag. No other costs would be incurred to sell the peanuts. All unsold bags can be returned to the supplier for $.30 each. Berry estimated the demand for peanuts at each football game and constructed the payoff table that follows. Demand Probability Action (Bags to Stock) (Bags) of Demand 20 30 40 50 20 .2 $20 $18 $16 $14 30 .4 $20 $30 $28 $26 40 .3 $20 $30 $40 $38 50 .1 $20 $30 $40 $50 The optimum number of bags of peanuts for Stan Berry to stock is

40

City Development, Inc., is considering a new investment project that will involve building a large office block in Frankfurt-am-Main. The firm's financial analysis department has estimated that the proposed investment has the following estimated rate of return distributions: Rate of Return Probability (5%) 30% 10% 50% 20% 20% Calculate the expected rate of return.

7.5%

Fact Pattern: The probabilities shown in the table below represent the estimate of sales for a new product. Sales (Units) Probability 0-200 15% 201-400 45% 401-600 25% 601-800 15% What is the probability of selling between 201 and 600 units of the product?

70%

Fact Pattern: The state of the economy has a strong effect on the expected returns for Techspace, Inc., as shown below: State of the Economy Probability Techspace Returns Recession .35 -10% Stable .40 10% Expansion .25 30% What is the expected rate of return on Techspace, Inc., stock?

8%

In general terms, a remainder interest refers to someone with a future interest in an asset. It may be a future interest in the estate created by a trust, a contingent interest when a life tenant surrenders a claim to the estate, or a vested interest that becomes effective at a specified future date.

864

Expected value in decision analysis is

An arithmetic mean using the probabilities as weights.

Probability (risk) analysis is

An extension of sensitivity analysis.

A company is evaluating its experience with five recent investments. The following data are available: Cost of Amount Investment Investment Received A $ 8,500 $ 8,390 B 4,200 4,610 C 12,100 12,400 D 7,900 8,220 E 11,000 11,400 Rank the investments in order from highest rate of return to lowest

B, D, E, C, A.

One type of risk to which investment securities are subject can be offset through portfolio diversification. This type of risk is referred to as

Company unique risk.

The reasonableness of management's accounting estimates

Considers that management bases its judgment on both subjective and objective factors.

Which of the following forecasting methods relies mostly on judgment?

Delphi.

Management utilizes all of the following procedures to develop accounting estimates except

Emphasizing historical experience.

The risk of loss because of fluctuations in the relative value of foreign currencies is called

Exchange rate risk.

Prior to the introduction of the euro, O&B Company, a U.S. corporation, is in possession of accounts receivable denominated in Deutsche marks. To what type of risk are they exposed?

Exchange-rate risk.

Management utilizes all of the following procedures to develop accounting estimates except

Excluding uncertainty from assumptions.

Catherine & Co. has extra cash at the end of the year and is analyzing the best way to invest the funds. The company should invest in a project only if the

Expected return on the project exceeds the return on investments of comparable risk.

Which tool would most likely be used to determine the best course of action under conditions of uncertainty?

Expected value (EV).

Which of the following is most useful when risk is being prioritized?

Expected value.

Which of the following factors is not characteristic of the efficient markets hypothesis?

Financial managers can benefit from timing the sales and purchases of securities.

Fact Pattern: The Booster Club at Blair College sells hot dogs at home basketball games. The group has a frequency distribution of the demand for hot dogs per game and plans to apply the expected value decision rule to determine the number of hot dogs to stock. The Booster Club should select the demand level that

Has the greatest expected monetary value.

Standard deviation and expected return information for four investments selling for the same price is as follows: Investment Standard Deviation Expected Return A 25% 20% B 20% 18% C 12% 8% D 10% 10% What investment is the best choice in terms of the risk/return relationship?

Investment D.

Russell, Inc., is evaluating four independent investment proposals. The expected returns and standard deviations for each of these proposals are presented below. Investment Expected Standard Proposal Returns Deviation I 16% 10% II 14% 10% III 20% 11% IV 22% 15% Which one of the investment proposals has the least risk per unit of return?

Investment III.

An entity is examining potential investments and notes that 1-year maturity yields are higher than those for 10-year maturities. Which of the following explanations for this occurrence is best?

Investors are expecting reduced inflation in the future as reflected in the lower long-term returns.

Management's financial estimates are based on all of the following except:

Irrelevance.

The expected monetary value of an event

Is equal to the payoff of the event times the probability the event will occur.

The risk that securities cannot be sold at a reasonable price on short notice is called

Liquidity risk.

When purchasing temporary investments, which one of the following best describes the risk associated with the ability to sell the investment in a short period of time without significant price concessions?

Liquidity risk.

Fact Pattern: An investor is considering the purchase of one of two common stocks. The projected returns for the two stocks and the probabilities for each are listed below: Marcel Company Stock Gilberte Company Stock Rate of Rate of Return Probability Return Probability 6.0 % 10% 7.0 % 25% 4.0 % 40% 5.0 % 25% 2.0 % 40% 0.0 % 25% (2.0)% 10% (1.0)% 25% Based on an expected rate of return calculation, which stock should the investor purchase?

Marcel Company's, because its expected rate of return is slightly higher.

The type of risk that is undiversifiable and affects the value of a portfolio is

Market risk.

A financial institution looking to assess its investment portfolio's exposure to price changes most likely would use which of the following techniques?

Market value at risk analysis.

Management should obtain and evaluate sufficient appropriate data to support significant accounting estimates. Differences between the estimates best supported by the data and those in the financial statements

May be individually reasonable but collectively indicate possible bias.

Management utilizes all of the following procedures to develop accounting estimates except

Minimizing disclosure of underlying assumptions.

Because of the large number of factors that could affect the demand for its new product, interactions among these factors, and the probabilities associated with different values of these factors, the marketing department would like to develop a computerized model for projecting demand for this product. By using a random-number procedure to generate values for the different factors, it will be able to estimate the distribution of demand for this new product. This method of estimating the distribution of demand for the new product is called

Monte Carlo simulation.

Which of the following may be used to estimate how inventory warehouse costs are affected by both the number of shipments and the weight of materials handled?

Multiple regression analysis.

The expected rate of return for the stock of Cornhusker Enterprises is 20%, with a standard deviation of 15%. The expected rate of return for the stock of Mustang Associates is 10%, with a standard deviation of 9%. The stock with the worse risk/return relationship is

Mustang because the coefficient of variation is higher.

According to recent focus sessions, Norton Corporation has a "can't miss" consumer product on its hands. Sales forecasts indicate either excellent or good results, with Norton's sales manager assigning a probability of .6 to a good results outcome. The company is now studying various sales compensation plans for the product and has determined the following contribution margin data: Contribution Margin If sales are excellent and Plan 1 is adopted $300,000 Plan 2 is adopted 370,000 If sales are good and Plan 1 is adopted 240,000 Plan 2 is adopted 180,000 On the basis of this information, which of the following statements is correct?

Plan 1 should be adopted because it is $8,000 more attractive than Plan 2.

Management's financial estimates are based on all of the following except

Prespecifications

Through the use of decision models, managers thoroughly analyze many alternatives and decide on the best alternative for the company. Often the actual results achieved from a particular decision are not what was expected when the decision was made. In addition, an alternative that was not selected would have actually been the best decision for the company. The appropriate technique to analyze the alternatives by using expected inputs and altering them before a decision is made is

Sensitivity analysis.

The expected monetary value of an act is the

Sum of the conditional profit (loss) for each event times the probability of each event's occurrence.

To help assure the reasonableness of an entity's accounting estimates, management probably is concerned about assumptions that are

Susceptible to bias.

The risk to which all investment securities are subject is known as

Systematic risk.

To assist in an investment decision, Gift Co. selected the most likely sales volume from several possible outcomes. Which of the following attributes would that selected sales volume reflect?

The greatest probability.

Fact Pattern: A company is considering three alternative machines to produce a new product. The cost structures (unit variable costs plus avoidable fixed costs) for the three machines are shown as follows. The selling price is unaffected by the machine used. Single purpose machine $.60x + $20,000 Semiautomatic machine $.40x + $50,000 Automatic machine $.20x + $120,000 The demand for units of the new product is described by the following probability distribution. Demand Probability 200,000 0.4 300,000 0.3 400,000 0.2 500,000 0.1 Using the expected value criterion,

The semiautomatic machine should be used because it has the lowest expected cost.

An accountant has been retained by a company as an investment advisor for its employees. Research of historical rates of return yields the following information: Type of Investment Mean Return Standard Deviation Common stocks 12% 20% Long-term corporate bonds 6% 8% Intermediate-term government bonds 5% 5% U.S. Treasury bills 4% 3% Which of the following investments has the greatest risk-return tradeoff if a return's standard deviation is an accurate assessment of investment risk?

U.S. Treasury bills.

An investor is currently holding income bonds, preferred stocks, subordinated debentures, and U.S. Treasury bonds. Which of these securities traditionally is considered to have the least risk?

U.S. Treasury bonds.

Which of the following classes of securities are listed in order from lowest risk/opportunity for return to highest risk/opportunity for return?

U.S. Treasury bonds; corporate first mortgage bonds; corporate income bonds; preferred stock.

The marketable securities with the least amount of default risk are

U.S. Treasury securities.

When making fair value estimates and disclosures, management most likely should

Understand the entity's process for determining fair value estimates to assess the risks of material misstatement.

A U.S. company currently has domestic operations only. It is considering an equal-size investment in either Canada or Britain. The data on expected rate of return and the risk associated with each of these proposed investments are given below. Proposed Investment Expected Rate of Return Standard Deviation British Investment 22% 10% Canadian Investment 28% 15% The expected rate of return on the company's current, domestic only, business is 20% with a standard deviation of 15%. Using the above data and the correlation coefficients, the company calculated the following portfolio risk and return (based on a ratio of 50% U.S. domestic operations and 50% international operations). Proposed Investment Expected Rate of Return Standard Deviation U.S. and Britain 21% 3% U.S. and Canada 24% 15% The company plans to select the optimal combination of countries based on risk and return for the domestic and international investments taken together. Because the company is new to the international business environment, it is relatively risk averse. Based on the above data, which one of the following alternatives provides the best risk-adjusted return to the firm?

Undertake the British investment.

In decision making under conditions of uncertainty, expected value refers to the

Weighted average of probable outcomes of an action.

Which of the following types of risk can be reduced by diversification?

labor strikes