Olter Inc Is Starting Its Risk Management Program For The Co

Olter Inc Is Starting Its Risk Management Program For The Company An

Olter Inc is starting its risk management program for the company and has asked for your help in determining critical risk measurements for the firm. The company has identified several factors in the market that they believe are critical for your tasks: The risk-free rate is 6%. The required return on the average stock is 13%. Olter’s average return is 13%.

Required: What is Olter’s beta coefficient? How does the beta coefficient influence the firm’s stock value? What is the required rate of return for Olter? In terms of risk, how does Olter compare to the average firm in the market?

If Olter’s beta increased to 1.6, what would you expect to happen to the required rate of return and what does this mean for the firm?

Paper For Above instruction

Olter Inc., as it embarks on establishing a comprehensive risk management program, must evaluate its risk profile through various financial metrics and models. A fundamental aspect of understanding its market risk exposure is calculating its beta coefficient, which measures the stock's volatility relative to the overall market. This calculation informs investors and managers about the stock's sensitivity to market movements, influencing both valuation and risk management strategies.

Calculating Olter’s Beta Coefficient

Given that Olter’s average return aligns with the required return on the market portfolio at 13%, and the risk-free rate is 6%, we can apply the Capital Asset Pricing Model (CAPM) to estimate beta. The CAPM formula is:

Required Return = Risk-Free Rate + Beta × (Market Return - Risk-Free Rate)

Rearranged to solve for beta:

Beta = (Required Return – Risk-Free Rate) / (Market Return – Risk-Free Rate)

Substituting the known values:

Beta = (0.13 – 0.06) / (0.13 – 0.06) = 0.07 / 0.07 = 1.0

Thus, Olter’s beta coefficient is estimated at 1.0, indicating that the company's stock moves in perfect proportion with the overall market.

Implications of the Beta Coefficient

The beta coefficient significantly influences a firm’s stock value by reflecting its systematic risk, which cannot be diversified away. A beta of 1.0 suggests that Olter’s stock exhibits average market risk and is expected to respond proportionally to market fluctuations. A higher beta implies greater volatility and potential for higher returns, but also increased risk exposure. Conversely, a lower beta indicates less volatility relative to the market.

In the context of valuation, investors use beta to adjust their risk premiums. A higher beta results in a higher required rate of return, compensating investors for extra risk exposure, and vice versa. Therefore, understanding beta helps in making informed investment decisions and aligning the firm's risk profile with shareholder expectations.

Calculating the Required Rate of Return for Olter

Using the CAPM formula:

Required Return = Risk-Free Rate + Beta × (Market Return – Risk-Free Rate)

Substituting the values:

Required Return = 6% + 1.0 × (13% – 6%) = 6% + 7% = 13%

This confirms that the required rate of return aligns with the company's average return, consistent with the initial assumptions.

Risk Comparison Between Olter and the Market

Given the beta of 1.0, Olter’s stock bears average market risk. It is neither more volatile nor less volatile than the overall market, suggesting that its risk profile is typical among publicly traded firms. This equivalency indicates that Olter's stock would likely respond to economic shocks, industry trends, and macroeconomic variables similarly to the market index.

Effect of an Increased Beta to 1.6

If Olter’s beta increased to 1.6, the systematic risk exposure would substantially rise. Applying the CAPM:

Required Return = 6% + 1.6 × (13% – 6%) = 6% + 1.6 × 7% = 6% + 11.2% = 17.2%

The increase in the required return from 13% to approximately 17.2% indicates that investors would demand a higher return for holding Olter’s stock due to its increased volatility and risk. This heightened required return directly impacts the company's valuation, potentially decreasing stock price unless the company can generate proportionally higher returns. This demonstrates the intrinsic link between beta, risk perception, and the cost of capital for the firm.

From a managerial perspective, a rising beta could signal the need for strategic actions to mitigate risk or capitalize on volatile market conditions to sustain shareholder value.

Conclusion

In summary, Olter’s beta coefficient provides critical insight into its systematic risk exposure, influencing its valuation and investment appeal. The initial beta of 1.0 indicates average market risk, while an increase to 1.6 suggests higher volatility, necessitating a higher required return. Understanding these risk measures and their implications helps the firm in strategic planning, investor communication, and risk mitigation efforts.

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