Oltor 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 initiating its risk management program and requires assistance in calculating key risk measurement metrics for the firm. The company has identified several market factors deemed critical for assessment, including the risk-free rate, the required return on the average stock, and Olter's specific return. The provided data includes:

  • The risk-free rate is 6%
  • The required return on the average stock is 13%
  • Olter’s average return is 13%

Based on these data points and the context of the Capital Asset Pricing Model (CAPM), the assignment involves calculating Olter’s beta coefficient, understanding its influence on stock valuation, determining Olter’s required rate of return, and comparing its risk profile to that of the average firm in the market. Additionally, an exploration is required on how an increase in Olter’s beta to 1.6 would affect the expected return and what this implies for the firm.

Paper For Above instruction

Understanding the risk profile of a firm is essential in finance, particularly through the lens of the Capital Asset Pricing Model (CAPM), which links expected return to systematic risk measured by beta. Olter Inc., embarking on its risk management journey, necessitates the calculation and interpretation of its beta coefficient and related risk metrics to inform investment decisions, risk assessments, and strategic planning.

To determine Olter’s beta coefficient, we leverage the CAPM equation:

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

Given the data, the expected return on Olter’s stock is 13%, the risk-free rate is 6%, and the market risk premium is calculated as the difference between the required return on the market (13%) and the risk-free rate (6%), which equals 7%. Substituting these into the equation gives:

13% = 6% + Beta × 7%

Solving for Beta:

Beta = (13% - 6%) / 7% = 7% / 7% = 1.0

Thus, Olter's beta coefficient is 1.0, indicating that the stock has a systematic risk level equal to the average of the market. A beta of 1 suggests that Olter’s stock is expected to move in tandem with the overall market, which is significant for investors as it influences the stock’s valuation and risk premium.

Beta’s influence on stock value is profound. When investors perceive higher systematic risk (a higher beta), they demand a higher expected return to compensate for this risk, leading to a lower present value of future cash flows. Conversely, a lower beta indicates less risk and potentially higher valuation if all other factors remain constant.

In terms of risk comparison, with a beta of 1.0, Olter is considered to have average market risk—risks that are neither mitigated nor amplified relative to the market as a whole. This positioning affects investment decisions, portfolio diversification strategies, and risk management policies.

If Olter’s beta increases from 1.0 to 1.6, the expected return, per CAPM, would shift accordingly. Reapplying the formula:

Expected Return = 6% + 1.6 × 7% = 6% + 11.2% = 17.2%

This significant increase in the required rate of return signifies that the market perceives Olter as considerably riskier. The higher required return reflects increased systematic risk, compelling investors to demand a greater compensation for holding the stock. For the firm, this could translate into higher capital costs, potentially affecting valuation, financing strategies, and investment opportunities.

From a risk management perspective, an increased beta underscores the importance of implementing measures to mitigate exposure to systematic market risks or diversify the company's portfolio to offset increased volatility. It also highlights the importance of aligning strategic decisions with risk appetite and market conditions.

In conclusion, the beta coefficient serves as a crucial indicator of a firm's systematic risk relative to the market. Olter’s initial beta of 1.0 places it at average market risk, but an increase to 1.6 signifies elevated risk and required returns, influencing both stock valuation and strategic risk management. Monitoring and adjusting to changes in beta are vital for aligning risk and return objectives in a dynamic market environment.

References

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