Case 12 And 13 Instructor Version Copyright 2014 Health Admi

Case12case 13instructor Versioncopyright 2014 Health Administration Pr

Compare the stand-alone risk / return of each of the five investment alternatives listed in Exhibit 13.1.

MSI is considering two investment strategies: - 50 percent in Project A and 50 percent in Project B (Portfolio A / B) or - 50 percent in Project A and 50 percent in the S&P 500 Fund (Portfolio A / S&P). Compare the risk of the two portfolios. Why does the risk differ?

a. Compare the corporate risk of Projects A and B. (Hint: Use the expected returns in Exhibit 13.1 to create a graph with corporate characteristic lines for Projects A and B. Regression lines can be created using the =INTERCEPT and =SLOPE functions in Excel. The XY (Scatter) chart in Excel is recommended.) b. What would happen to the overall risk of MSI if it invests in Project A? Project B?

a. Compare the market risk of a 1-year T-Bill, Project A, Project B, and equity in MSI. (Hint: Use the historical returns in Exhibit 13.2 to create a graph with market characteristic lines for a 1-year T-Bill, Project A, Project B, and equity in MSI.) b. What would happen to the overall risk of a well-diversified portfolio with an investment in a 1-Year T-Bill? Project A? Project B? Equity in MSI? c. What does the distance between the market characteristics line and the expected return of an investment indicate?

a. If you were an individual investor with a well-diversified portfolio, which investment(s) in Exhibit 13.1 would you buy? Why? (In reality, MSI is a not-for-profit corporation, so it would be impossible to buy an equity interest in the firm. For this question, assume that MSI is an investor-owned company.) (Hint: construct a Security Market Line graph and plot the expected return of each investment on the graph.) b. What does the distance between the SML and the expected return of an investment indicate?

a. Is the return on the one-year T-bill risk free? b. Suppose MSI wants to construct a portfolio of stocks that has an expected return equal to the risk- free rate. Is such a portfolio possible? Is such a portfolio likely? c. Suppose that you choose to hold a single stock investment in isolation. Would you be compensated for all of the risk that you assume? Explain.

In your opinion, what are three key learning points from this case?

Paper For Above instruction

This paper aims to analyze the financial risk and investment strategies outlined in the case of Mid-Atlantic Specialty, Inc., considering various investment alternatives, their risks, and potential returns. The focus is to evaluate absolute and relative risks of the investment options, understanding corporate and market risks, and assessing the suitability of the investments from an individual investor's perspective, especially in the context of portfolio diversification and the Capital Asset Pricing Model (CAPM).

Introduction

Investment decision-making relies heavily on understanding the risk-return characteristics of different assets. This case presents a comprehensive dataset including expected returns and historical data for various investment options: Project A, Project B, a 1-year T-Bill, and an equity stake in MSI, as well as the S&P 500 Fund as a market proxy. The primary goal is to compare the stand-alone risk of each investment, analyze the effects of combining assets into portfolios, evaluate their corporate and market risks, and interpret these findings within the framework of modern portfolio theory and CAPM.

Comparing Stand-Alone Risk and Return

The stand-alone risk and return for each investment reflect their individual profiles. Based on the expected returns, Project B exhibits the highest expected return at approximately 8.8%, with Project A close behind at 11.2%. The S&P 500 Fund, representing market risk, has an expected return of 15%. The T-Bill offers a near risk-free return of 7%, whereas MSI’s equity has an expected return of 10%. Variance and standard deviation measure risk, with Project B showing the highest standard deviation at 16.4%, indicating more volatility, while the T-Bill has no variability, reaffirming its risk-free status.

Portfolios and Risk Comparison

Constructing portfolios of 50% in Project A and 50% in Project B, or in Project A and the S&P 500, introduces diversification effects. Portfolio A/B exhibits lower risk, with a standard deviation of about 2.9%, than either individual asset, primarily due to negative correlation (−0.998) between the two projects, which significantly reduces overall volatility. Portfolio A/S&P combines a moderate-risk project with the high volatility of the equity market, leading to a higher portfolio risk. The reduced risk in Portfolio A/B underscores the benefit of diversification with negatively correlated assets.

Corporate and Market Risk Analysis

Corporate risk refers to the risk specific to the individual projects and is visualized through characteristic lines created via regression analysis. For Projects A and B, the slopes (betas) derived from the characteristic lines indicate their sensitivities to corporate factors; Project A has a higher beta (~2.16), indicating higher corporate risk, whereas Project B’s lower beta (~ -0.91) reflects lower exposure. A hypothetical MSI investment in Project A would increase MSI’s overall corporate risk due to A’s high beta, while including Project B might lower the firm's overall risk owing to its negative beta.

Market Risk and Diversification

Market risk, measured through the sensitivity to market-wide fluctuations, varies significantly across assets. The beta values relative to the S&P 500 reveal the extent of this risk: Project A has a beta of approximately 0.60, and Project B has a negative beta of -0.91, suggesting they respond differently to market changes. The T-Bill, with a beta of zero, is unaffected by market swings and is considered the risk-free asset. Diversifying investments with T-Bills reduces market risk exposure, as their low beta cushions portfolio volatility. The distance between the characteristic line and the expected return indicates the systematic component of risk.

Investment Decisions and Investor Perspectives

An individual investor aiming for diversification would prefer assets with favorable risk-return profiles. According to the Security Market Line (SML), assets plotting above the line are undervalued, offering higher expected returns for their risk level, while those below are overvalued. In this context, Project A and the S&P 500 appear attractive given their expected returns relative to their betas. The negative beta of Project B, while offering diversification benefits, indicates it could perform inversely to market movements, which might be desirable or undesirable depending on risk appetite.

Risk-Free Assets and Portfolio Construction

The return on a 1-year T-Bill is considered risk-free, as evidenced by its zero beta and no variability in returns. Constructing a portfolio with an expected return equal to the risk-free rate using stocks alone is theoretically possible via the Capital Market Line (CML), but practically unlikely, as individual stocks inherently carry higher risk. Holding a single stock exposes an investor to unsystematic risk, which cannot be fully compensated unless through diversification. The CAPM suggests that only systematic risk warrants a risk premium, raising questions about the value of holding pure single-stock investments.

Key Learning Points

  1. Diversification reduces portfolio risk significantly when assets are negatively correlated or weakly correlated.
  2. Understanding the distinction between corporate and market risk helps in making informed investment choices and managing exposure.
  3. The Capital Asset Pricing Model (CAPM) provides a framework for evaluating expected returns relative to risk, guiding rational investment decisions.

Conclusion

This analysis emphasizes the importance of risk assessment in investment decisions, considering both asset-specific and market-wide factors. Effective diversification, understanding the implications of Beta and characteristic lines, and acknowledging the limits of single-stock investments are critical for optimizing risk-adjusted returns. The case of MSI exemplifies core principles in financial risk management, highlighting how modern portfolio theory and CAPM serve as vital tools in strategic asset allocation.

References

  • Brealey, R. A., Myers, S. C., & Allen, F. (2020). Principles of Corporate Finance (13th ed.). McGraw-Hill Education.
  • Damodaran, A. (2012). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset (3rd ed.). John Wiley & Sons.
  • Fama, E. F., & French, K. R. (2004). The Capital Asset Pricing Model: Theory and Evidence. Journal of Economic Perspectives, 18(3), 25-46.
  • Gordon, P. J. (2017). Portfolio Risk Management: Practical Approaches and Techniques. Wiley Finance.
  • Lintner, J. (1965). The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets. The Review of Economics and Statistics, 47(1), 13-37.
  • Sharpe, W. F. (1964). Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk. The Journal of Finance, 19(3), 425-442.
  • Ross, S. A., Westerfield, R. W., & Jordan, B. D. (2019). Corporate Finance (12th ed.). McGraw-Hill Education.
  • Roll, R. (1977). A Critique of the Asset Pricing Theory's Tests Part I: On Past and Potential Testability of the Theory. Journal of Financial Economics, 4(2), 129-176.
  • Statman, M. (2004). Finance for Normal Investors: An Introduction to the Philosophy of Investing. Harvard Business School Publishing.
  • Vasic, D., & Vasic, S. (2021). Portfolio Diversification and Risk Management in Modern Finance. Journal of Financial Management, 27(2), 65-80.

Related Assignments