Risk Defined Risk refers to potential variability in future cash flows. The wider the range of possible future cash flows that can occur, the greater the risk. Thus,the returns on common stock are more risky than returns from investing in a savings account in a bank
Risk Defined Risk refers to potential variability in future cash flows. n The wider the range of possible future cash flows that can occur, the greater the risk. Thus, the returns on common stock are more risky than returns from investing in a savings account in a bank
What is Risk?Both Upside and Downside Some risks are more complex.A computer mother-board manufacturer that underestimates demand will lose current sales and market share overestimates demand will own an inventory with a market price that is being eroded by rapid technological obsolescence TAnydeviation is a risk and unfavorable
What is Risk? Both Upside and Downside Some risks are more complex. A computer mother-board manufacturer that underestimates demand will lose current sales and market share overestimates demand will own an inventory with a market price that is being eroded by rapid technological obsolescence THECOURASE OnF FyINANCdE 2e017vSPRi INaG St JTi U on is a risk and unfavora7 ble
What is Risk?20/20 Hindsight The appropriateness of a risk- management decision should be determined using only the information available when the decision was made D We should avoid coloring our judgement of a earlier decision with facts know after the decision But .. THE COURSE OF FINANCE 2017 SPRING SJTU
What is Risk? 20/20 Hindsight The appropriateness of a risk- management decision should be determined using only the information available when the decision was made We should avoid coloring our judgement of a earlier decision with facts know after the decision But ... THE COURSE OF FINANCE 2017 SPRING SJTU 8
Example1 Suppose you are aware of the following investment opportunity:You could open a coffee shop around the corner from your home for $25,000.If business is strong,you could net $15,000 in after-tax cash flows each year over the next 5 years. a.If you knew for certain the business would be a success,would this be a risky investment? b.Now assume this is a risky venture and that there is a 50%chance it is a success and a 50%chance you go bankrupt within 2 years.You decide to go ahead and invest.If the business subsequently goes bankrupt,did you make the wrong decision based on the information you had at the time?Why or why not? THE COURSE OF FINANCE 2017 SPRING SJTU
Example1 Suppose you are aware of the following investment opportunity: You could open a coffee shop around the corner from your home for $25,000. If business is strong, you could net $15,000 in after-tax cash flows each year over the next 5 years. a. If you knew for certain the business would be a success, would this be a risky investment? b. Now assume this is a risky venture and that there is a 50% chance it is a success and a 50% chance you go bankrupt within 2 years. You decide to go ahead and invest. If the business subsequently goes bankrupt, did you make the wrong decision based on the information you had at the time? Why or why not? THE COURSE OF FINANCE 2017 SPRING SJTU 9
What is Risk?Preserving your Options But .. a decision that preserves the ability to make in-flight corrections (at a small cost)over one that disposes of that ability characterizes a well-made decision “Preserve your options'” THE COURSE OF FINANCE 2017 SPRING SJTU 10
What is Risk? Preserving your Options But … a decision that preserves the ability to make in-flight corrections (at a small cost) over one that disposes of that ability characterizes a well-made decision “Preserve your options” THE COURSE OF FINANCE 2017 SPRING SJTU 10