Essay: Risk & Return, Capital Budgeting, Sensitivity Analysis - Calculating & Analyzing.

Calculate the following using the data from Yahoo Finance  for the company you selected for Question 1 of Assignment

1. Calculate the daily market return over the last five years from the daily prices, calculate the monthly returns from the daily returns, and calculate the yearly returns from the monthly returns.
2. Calculate the total risk (i.e. yearly standard deviation of the daily returns).
3. Calculate the yearly systematic / market risk using the daily returns of the stock and daily return of the market index.
4. Calculate the unsystematic risk / firm specific risk. Suggest whether this company is a good investment. Answer the following questions while making your suggestion.

a) What is the basis for selection of this stock if you suggest this as a good investment?

b) Would you invest all your money into this stock? If not, why not? How will you address this concern?

ABC Ltd. would like to set up a new expansion plant. Currently, ABC has an option to buy an existing building at a cost of AUD 24 000. Necessary equipment for the plant will cost AUD 16 000, including installation costs. The economic life of the equipment and building are 5 and 40 years, respectively. The project also requires an initial investment of AUD 12 000 in net working capital. The initial working capital investment will be made at the time of the purchase of the building and equipment.

The project’s estimated economic life is four years. At the end of that time, the building is expected to have a market value of AUD 15 000 and a book value of AUD 21 600, whereas the equipment is expected to have a market value of AUD 4 000 and a book value of AUD 3 200.

Annual sales will be AUD 80 000. The production department has estimated that variable manufacturing costs will total 60% of sales and that fixed overhead costs, excluding  depreciation, will be AUD 10 000 a year. Depreciation expense will be determined for the year using straight line depreciation method.

ABC’s tax rate is 40%; its cost of capital is 12%; and, for capital budgeting purposes, the company’s policy is to assume that operating cash flows occur at the end of each year. The plant will begin operations immediately after the investment is made, and the first operating cash flows will occur exactly one year later.

1. Compute the initial investment outlay, operating cash flow over the project’s life, and the terminal-year cash flows for ABC’s expansion project.
2. Determine whether the project should be accepted using NPV analysis.
3. Do the sensitivity analysis using different levels of change (e.g. 2%, 5% and 10% increase and decrease) of each of the key inputs (e.g., sales, variable costs and cost of capital)
4. Identify the most sensitive factor
5. Perform the scenario analysis

Monthly return of OEL

In this question, Origin Energy Limited Company (OEL) is selected for the investment purpose. OEL is traded on an Australia Stock Exchange (AX).

OEL’s historical daily data of last 5 years that is April, 01 2012 to March, 31 2017 was taken from https://au.finance.yahoo.com/.

Now, detailed analysis of return and risk of OEL and market (AX) is calculated below:

Calculation of Daily return, monthly return and yearly return of OEL and market (ASX) from April, 01 2012 to March, 31 2017 (Source: https://au.finance.yahoo.com/, 2017).

• Refer MS-Excel sheet for the daily returns of OEL and market from April, 01 2012 to March, 31 2017.
• Monthly Returns of OEL and market from April,01 2012 to March, 31 2017 is below:

    (Source: https://au.finance.yahoo.com/, 2017).

Monthly return of Market (AX)

 (Source: https://au.finance.yahoo.com/, 2017).

• Yearly Returns of OEL and market from April,01 2012 to March, 31 2017 is below:

2. Below is the calculation of yearly Total Risk (σ) of OEL and market index (AX):

3. Below is the calculation of yearly Systematic Risk of OEL:

4. Below is the calculation of yearly Un-Systematic Risk of OEL:

Before answering OEL is good or not for investment decisions, following terms required to be understood:

As everyone knows that both risk and return is the characteristics of the investment.

• Return:Returns of the company form the basis for the investment decisions to the investor. If the returns are highly fluctuating, then it is called as high risk investments. Thus, considering the returns of the OEL for 2015-2016 and 2016-2017, shows drastically growth from -47.32% to 39.81%. Hence, on the basis of returns this is considered as good investments (Banz, 1981).
• Risk (σ):Risk is correlated with the returns of the company. It is calculated to find out the deviations in the returns which are the best measure of analysing risks. It is a sum of Systematic risk and Unsystematic risk (Kaplan and Garrick, 1981).
• Systematic Risks: It is based on external factors and this risk is not controlled by the company because it is related with the market. Investor needs to consider this risk for its investment decisions.

It is calculated by using stock returns and the market index returns. In this case, considering the past trends of OEL, it is seen that Systematic risk showing the slightly upward trend which indicates that OEL is a good for the investment (Klemkosky and Martin, 1975 ; Lakonishok, and Shapiro,1986).

• Un-Systematic Risks: It is based on internal company’s factor and which company has a control over this risk. This risk can be eliminated but it is not important for the investor to consider this risk for investment decisions (Tang and Shum, 2003).

Therefore, on the basis of above understanding it can be said that OEL is a good for the investment.

Criteria: Return of 2016-2017, showing a positive return as compared to 2015-2016 which was negative and also it is observed that systematic risk of 2016-2017 is slightly showing upward trend from 2015-2016. On the basis of these two criteria, an investor should select this stock for investment.

No, investor should not invest all of his money into this stock; instead he should invest in diversified securities so that its return and risk is minimum.

• Cost of the building = AUD 24,000
• Life of the building = 40 years
• Cost of the equipment (incl. installation costs) = AUD 16,000
• Life of the equipment = 5 years
• Investment in net working capital = AUD 12,000
• Project’s Life = 4 years
• Annual Sale = AUD 80,000
• Variable manufacturing cost is 60% of total sales = 60% of AUD 80,000 = AUD 48,000
• Fixed overhead cost (excl. depreciation) = AUD 10,000
• Taxation rate = 40%
• Depreciation is calculated with Straight line method
• Cost of capital (discount rate) = 12%
• Building                                  Equipment
  • Market Value            AUD 15,000                         AUD 4,000
  • Book Value AUD 21,600                         AUD 3,200

2. NPV:

Since NPV is positive, ABC Ltd. should accept the project of new expansion plant.

3.Sensitivity Analysis: It is used for the measurement of the risk. This is calculated by changing one variable at one time and keeping all the other variables constant (Saltelli, Chan and Scott, 2000).

In this question, sensitivity analysis is measured using 10% level of change in both ways with respect to sales, variable cost and cost of capital.

1. Sensitivity analysis of sales:

• Let us assume Sales be increased by 10% i.e. AUD 80,000 + 10% = AUD 88,000.

• Let us assume Sales be decreased by 10% i.e. AUD 80,000 - 10% = AUD 72,000.

1. Sensitivity analysis of Variable costs:

• Let us assume variable costs be increased by 10% i.e. AUD 48,000 + 10% = AUD 52,800.

• Let us assume variable costs be decreased by 10% i.e. AUD 48,000 - 10% = AUD 43,200.

Now the revised NPV is calculated as follows:

1. Sensitivity analysis of Cost of capital:

• Let us assume cost of capital be increased by 10% i.e. 12% + 10% = 13.2%

• Let us assume cost of capital be decreased by 10% i.e. 12% - 10% = 10.8%

Now the revised NPV is calculated as follows:

13.  Calculation of Present value factor of 13.2% of 4 years:

10.  Calculation of Present value factor of 10.8% of 4 years:

5. Scenario Analysis: It is the extension of the sensitivity analysis because it considers changing of 2 variables at one time so that combined effect is obtained. It moves from Best case to the worst case of the outcome (The Economic times, 2017). It has 4 components:

• In 1^stcomponent, factor is determined which ranges from market to competitor’s response.
• 2^ndcomponent determines number of outcomes for each factor which can be best, average and worst.
• 3^rdcomponent focuses on critical factors for each outcome.
• Last in 4^thcomponent, probabilities are assigned to each factor.

References

Banz, R.W.,1981, The relationship between return and market value of the common stocks, Journal of financial economics, Vol.9, no.1, pp.3-18.

Kaplan, S. and Garrick, B.J., 1981, On the quantitative definition of risk, Risk analysis. Vol.1, no.1, pp. 11-27.

Klemkosky, R.C. and Martin, J.D.,1975, The adjustment of beta forecasts, the journal of finance, vol.30, no.4, pp.1123-1128.

Lakonishok, J. and Shapiro, A.C., 1986, Systematic risk, total risk and size as determinants of stock market returns, Journal of banking & finance, vol.10, no.1, pp,105-132.

Origin Energy Limited (ORG. AX), 2017, Historical Data, viewed on 3 April 2017, from <https://au.finance.yahoo.com/quote/ORG.AX/history?period1=1333218600&period2=1490898600&interval=1d&filter=history&frequency=1d>.

S&P/ASX 200(^AXJO), 2017, Historical Data, viewed on 3 April 2017, from <https://au.finance.yahoo.com/quote/%5EAXJO/history?period1=1333218600&period2=1490898600&interval=1d&filter=history&frequency=1d>.

Saltelli, A., Chan, K. and Scott, E.M., 2000, Sensitivity analysis, New York: Wiley.

Shapiro, A.C., 2005, Capital budgeting and investment analysis,Prentice hall.

Tang, G.Y. and Shum, W.C., 2003, The relationships between unsystematic risk, skewness and stock returns during up and down markets, international business review, vol.12, no.5, pp. 523-541.

The Economic times, 2017, definition of ‘scenario analysis’.